Final answer:
A note receivable is considered impaired when the creditor does not expect to receive all amounts due, and the present value of expected future cash flows is determined by discounting them at the note's original effective interest rate.
Step-by-step explanation:
A note receivable is considered to be impaired when the creditor no longer expects to receive all amounts due according to the original terms of the note. In that case, the present value of the expected future cash flows is determined by discounting those expected cash flows at the note's original effective interest rate.
For example, let's assume a company has a note receivable that was initially recorded at an 8% interest rate. If the company assesses impairment because the debtor is experiencing financial difficulties, it might project that it will not receive all the payments as originally agreed. When computing the new carrying amount of the impaired note, the company will discount the new expected cash flows at the original 8% interest rate, despite the current market rates.
It's important to realize that changes in interest rates can affect the present value calculation of future cash flows. The second calculation shows what happens if the interest rate rises from 8% to 11%. Even though the actual dollar payments agreed upon in the note do not change, the present value of those payments, now discounted at a higher interest rate of 11%, results in a lower present value. If the original note was based on an 8% interest rate, and the market rates increase, someone looking to sell the note may find its value has decreased because the discounted future cash flows are now lower.
In real-world situations, not only the market interest rate but also the riskiness of whether the borrower will repay affects the assessment and valuation of the note receivable.
The formula for calculating the present value of a future payment is:
The Future Value received years in the future is calculated using (1 + Interest rate)number of years t.
- For instance, a $20 million payment in one year at an 8% interest rate would be discounted by the factor of (1 + 0.08)1.
- Continuing, a $25 million payment in two years would be discounted by (1 + 0.08)2.