Receivables chapter 6 PDF

Preview

Summary

receivables ...

Description

Receivables – Additional Concepts Chapter 6 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 loan 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 and 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 are initially measured at fair value plus transaction costs. 

Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.



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 increases both the carrying amount of the loan and interest income.



Indirect origination costs are not included in the measurement of receivables. These are expensed immediately.

Direct origination costs and origination fees are included in the calculation of the effective interest rate. On transaction date, direct origination costs and origination fees are treated as adjustments to the effective interest rate.

Illustration On January 1, 2020, ABC Bank extended a 10%, P1,000,000 loan to XYZ, Inc. Principal is due on January 1, 2023 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 charges 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 2020. Solution

Principal amount Direct origination cost Origination fee (1,000,000 x 6%) Initial carrying amount of loan receivable

1,000,000 12,000 (60,000) 952,000

The indirect origination cost of P8,000 is charged immediately as expense and not included in the measurement of the loan receivable. Jan 1,202 0

Loan receivable Cash (1,000,000-60,000) Unearned interest income To record the release of loan, net of origination fees

1,000,000

Jan 1, 2020

Unearned interest income Cash To record the direct origination costs Administrative expense Cash To record the indirect origination costs.

12,000

Jan 1, 2020

940,000 60,000

12,000

As stated, 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, this rate can be computed using various methods, one of which is the trial and error approach. Trial and Error Before we use 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 at a premium.

When a financial instrument is at a discount, the effective interest rate is higher than the nominal rate. On the other hand, when a financial instrument is at a premium, the effective interest rate is lower than the nominal rate.

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. We know that the loan is issued at a discount because the initial carrying amount of P952,000 is less 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%. First Trial (11%)

Future cash flows × PV factor @ x %=Present value of note 

Principal of 1,000,000 x PV of 1 @ 11%, n=3 + Interest of 100,000 x PV of ordinary annuity @ 11%, n=3 = 952,000



(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, a difference of 23,563.

Second Trial (12%)

Future cash flows × PV factor @ x %=Present value of note 

Principal of 1,000,000 x PV of 1 @ 12%, n=3 + Interest of 100,000 x PV of ordinary 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 952,000, a difference of only 37.

If the difference of P37 is judged as immaterial, we can use 12% as the effective interest rate. In which case, no further interpolation is performed. If other tools are used, the exact imputed interest rate is 11.985489449%.

Date Jan 1, 2020 Jan 1, 2021 Jan 1, 2022 Jan 1, 2023

Collections of interests

Interest income

Amortization

Present value

100,000 100,000 100,000

114,240 115,949 117,963

14,240 15,949 17,963

952,000 966,240 982,189 1,000,052

Dec. 31,2020

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 amount of its liability on January 1, 2020 is determined as follows: Principal amount Discount on loan payable (1,000,000x6%)

1,000,000 (60,000)

Initial carrying amount of loan payable

940,000

Jan 1, 2020

Cash Discount on loan payable Loan payable

940,00 0 60,000

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: Day 1 Difference On January 1, 2020, ABC Co. extended a P1,000,000, zero-interest loan to one of its directors. The loan matures in lump sum on January 1, 2023. 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 Future cash flow Multiply by PV of P1@10%, n=3

1,000,000 0.751315

Present value of loan receivable

751,315

Face amount Present value of loan receivable

1,000,000 (751,315)

Unearned interest income

294,695

Jan 1, 2020

Loan receivable 1,000,00 Cash 0 751,315 Unearned interest 249,695 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)

751,315 (751,315)

Difference Case 2: Loan Proceeds Equal to Face Amount Assume that the loan proceeds extended to the director is equal to the face amount of the loan receivable Jan 1, 2020

Loan receivable Unrealized loss- day 1 difference Cash Unearned interest

1,000,00 0 248,685

1,000,00 0 248,685

An accounting problem arises in this case because the transaction price (price paid) is not equal to the fair value at initial recognition (present value). The difference (Day 1 difference) is recognized in profit or loss. Present value of loan receivable Transaction price (cash paid) Difference – unrealized loss Impairment

751,315 (1,000,000) (248,685)

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 multifactor 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 instruments that are not measured at fair value through profit or loss. The Expected Credit Loss Model (ECL) The ECL model requires three approaches depending on the type of asset or credit exposure. These are: Type of Asset/Exposure 1. Trade receivables, contract assets and lease receivables 2. Originated or purchased credit-impaired financial assets 3. Other assets/exposures

Approach  Simplified approach 

Changes in lifetime expected credit losses approach



General approach

General Approach The general approach is based on three stages which are intended to reflect the credit deterioration and improvement of a financial instrument. Stage 1 • Credit risk has not increased significantly since initial recognition. • Low credit risk expediency

Stage 2 • Credit risk has increased significantly since initial recognition.

Stage 3 • Credit risk has increased significantly since initial recognition plus there is objective evidence of impairment.

Stage 1  Recognize 12-month expected credit losses  Interest revenue is computed on the gross carrying amount of the asset

Stage 2  Recognize lifetime expected credit losses  Interest revenue is computed on the gross carrying amount of the asset

Stage 3  Recognize lifetime expected credit losses  Interest revenue is computed on the net carrying amount (i.e., gross carrying amount less loss allowance)

An entity recognizes a loss allowance for expected credit losses. 

Loss allowance – is the allowance for expected credit losses on financial assets that are within the scope of the impairment 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.



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, discounted at the original effective interest rate.

An entity recognizes a loss allowance for expected credit losses. 

Loss allowance – is the allowance for expected credit losses on financial assets that are within the scope of the impairment 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.



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, discounted at the original effective interest rate. 



Credit risk – the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation.

Low credit risk expediency: An entity may assume that the credit risk has not increased significantly since initial 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.

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 revenue is measured on the net carrying amount of the instrument.

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 recognized as a gain. Illustration: 12-Month vs. Lifetime Expected Credit Losses ABC Co. issues a 3-year, interest-bearing loan of P1,000,000 on August 1, 2020. ABC Co. makes the following estimates of risks and default losses:

Risk of default in: Next 12 months Remaining months 2.00% 5.00% 3.00% 12.00% 1.00% 3.00%

Date Aug. 1,2020 Dec 31,2020 Dec 31, 2021

Loss from default 400,000 350,000 250,000

Requirements: Compute for the amount of loss allowance on the following dates: a.

August 1, 2020

b.

December 31, 2020

c.

December 31, 2021

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.

Aug 1, 2020

Impairment loss 8,000 Loss allowance 8,000 At each reporting date, ABC Co. shall determine whether there has been a significant increase in credit risk since initial recognition. Risk of default in: Next 12 Months Remaining Months Total (a) (b) (c)= (a) + (b) Aug 1,2020 2.00% 5.00% 7.00% Dec 31, 2020 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 may be deemed significant (as it has more than doubled).

Date

Accordingly, ABC Co. shall measure the loss allowance equal to the lifetime expected credit losses of P52,500 (15% x 350,000). Dec 31, 2020

Impairment loss Loss allowance (52,500- 8,000)

44,500 44,500

ABC Co. shall again determine whether the credit risk has increased significantly since August 1, 2020. Risk of default in : Date Next 12 months Remaining months Total (a) (b) (c) = (a)+ (b) Aug 1, 2020 2.00% 5.00% 7.00% Dec 31, 2020 3.00% 12.00% 15.00% Dec 31, 2021 1.00% 3.00% 4.00% The total risk on December 31, 2021 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 from the lifetime expected credit losses to the 12-month expected credit losses. ABC Co. shall measure the loss allowance equal to 12-month expected credit losses of P2,500 (1% x 250,000). Dec 31, 2021

Loss allowance (52,500-2,500) Impairment gain Determining Significant Increases in Credit Risk

50,000 50,000

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. PFRS 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. 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. PFRS 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. PFRS 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 or collective basis. For purposes of determining the change in credit risk on a collective basis, an entity can group financial instruments on the basis of shared credit risk characteristics. Examples of Shared Credit Risk Characteristics a. Instrument type;

b. Credit risk ratings;

c. Collateral type; d. Date of initial recognition; e. Remaining term to maturity; f.

Industry;

g. Geographical location of the borrower; and h. The value of collateral relative to the financial asset if it has an impact on the probability of a default occurring.

Measurement of Expected Credit Losses Expected credit losses shall be measured in a m...