Accounting For Loan Impairments [Case Example]

Accounting for Loan ImpairmentLoan impairment arises when it is probable that the creditor may not be able to collect all of the principal and interest due on a loan. What is accounting treatment for loan impairment? What entries should be made? This post provides the answers. Enjoy!

 

Loan Impairment Case Example

Let’s assume that on December 31, 2006, the Lie Dharma Company issued a $1,000,000, five-year, non-interest-bearing note to the Putra Security Bank, yielding 10% per year. At the date of the issuance the Lie Dharma Company paid $620,920 = (1,000,000 x 0.62092). The following entries were made:

1. By the creditor, the Putra Security Bank:

[Debit]. Notes Receivable = $1,000,000
[Credit]. Discount on Notes Receivable = $379,080
[Credit]. Cash = $620,920

2. By the debtor, the Lie Dharma Company

[Debit]. Cash = $620,920
[Debit]. Discount on Notes Payable = $379,080
[Credit]. Notes Payable = $1,000,000

 

The following table shows the note discount amortization using the effective interest method:

First Loan Amortization Schedule

 

Now, let’s assume that because of bad economic conditions for the Lie Dharma Company, the Putra Security Bank estimates on December 31, 2008, that only $800,000 is collectable at the end of the five years. Therefore, it estimates its loss due to impairment as follows:

  • Carrying amount of the loan, 12/31/208 = $751,312.20
  • Present value of $800,000 due in 3 years at 10% compounded annually (800,000 x 0.75132) = $601,056.00
  • Loss due to impairment (751,312.20 – 601,056) = $150,256.20

 

Therefore, the Putra Security Bank made the following entry:

[Debit]. Bad Debt Expense = $150,256.20
[Credit]. Allowance for Doubtful Accounts = $150,256.20

 

The Lie Dharma Company does not make an entry. The Putra Security Bank prepares a new schedule of discount amortization based on the new carrying amount of $601,056. It is shown in the next table:

Second Loan Amortization Schedule

 

The following entries are made on Dec. 31, 2009:

1. By the Putra Security Bank

[Debit]. Discount on Notes Receivable = $75,131.32
[Credit]. Interest Revenue = $60,105.60
[Credit]. Allowance for Doubtful Accounts = $15,025.72

2. By the Lie Dharma Company

[Debit]. Interest Expense = $75,131.32
[Credit]. Discount on Notes Payable = $75,131.32

 

At the maturity date, on January 1, 2000, the Lie Dharma Company pays $800,000 and the following entries are made:

1. By the Putra Security Bank

[Debit]. Cash = $800,000
[Debit]. Allowance for Doubtful Accounts = $200,000
[Credit]. Notes Receivable = $1,000,000

2. By the Lie Dharma Company

[Debit]. Notes Payable = $1,000,000
[Credit]. Cash = $800,000
[Credit]. Gain on Extinguishment = $200,000