It may be necessary to account for a loan that is considered to be impaired. A business may own one or more loans that are payable by third parties. If the financial circumstances of these borrowers declines, the following issues may arise that require accounting treatment:
- Loan impairment. A loan is considered to be impaired when it is probable that not all of the related principal and interest payments will be collected.
- Impairment documentation. Any allowance for loan impairments should be fully documented with the appropriate analysis, and updated consistently from period to period.
- Impairment allowance. An impairment allowance can be based on the examination of individual receivables, or groups of similar types of receivables. The creditor can use any impairment measurement method that is practical for the creditor’s circumstances. When loans are aggregated for analysis purposes, you can use historical statistics to derive the estimated amount of impairment. The amount of impairment to recognize should be based on the present value of expected future cash flows, though a loan’s market price or the fair value of the related collateral can also be used. It is possible that there is no need to establish a reserve for an impaired loan if the value of the related collateral is at least as much as the recorded value of the loan.
- Impairment accounting. The offset to the impairment allowance should be the bad debt expense account. Once actual credit losses are identified, subtract them from the impairment allowance, along with the related loan balance. If loans are subsequently recovered, the previous charge-off transaction should be reversed.
As a result of impairment accounting, it is possible that the recorded investment in a loan judged to be impaired may be less than its present value, because the creditor has elected to charge off part of the loan.