Final answer:
A creditor uses an impairment loss calculation to evaluate the potential loss on a loan, considering the difference between the present value of expected cash flows and the fair value of the note. Banks anticipate a level of default in their planning, but higher than expected default rates can severely impact their balance sheet.
Step-by-step explanation:
When a creditor assesses a loan for impairment, they are evaluating the potential loss they may incur if a borrower is unable to repay the loan according to the original terms. The evaluation involves calculating the difference between the present value of the expected future cash flows, discounted using the historical effective interest rate, and the fair value of the loan or note. A well-run bank anticipates that a certain percentage of loans will not be repaid and incorporates this into their financial planning. However, if actual loan defaults exceed the expected number, as can happen during economic downturns, this can lead to a significant reduction in the bank's assets and may result in a negative net worth. For example, if the Safe and Secure Bank's loans decline in value from $5 million to $3 million due to unforeseen defaults, it would directly impact the bank's balance sheet.