Purchase of impaired debt
On 1 January 2006, Company D issued a debt instrument that required it to pay an annual coupon of €800 in arrears and to repay the principal of €10,000 on 31 December 2015. By 2011, D was in financial difficulties and was unable to pay the coupon due on 31 December 2011. On 1 January 2012, Company V estimated that the holder could expect to receive a single payment of €4,000 at the end of 2013 following a financial restructuring and acquired the debt instrument at an arms length price of €3,000.
It can be shown that using the contractual cash flows (including the €800 overdue) gives rise to an effective interest rate of 70.1% (the net present value of €800 now and annually thereafter until 2015 and €10,000 receivable at the end of 2015 is €3,000 when discounted at 70.1%). However, because the debt instrument has clearly incurred a credit loss, V should calculate the effective interest rate using the estimated cash flows on the instrument. In this case, the effective interest rate is 15.5% (the net present value of €4,000 receivable in two years is €3,000 when discounted at 15.5%).
All things being equal, interest income of €464 (€3,000 × 15.5%) would be recognised on the instrument during 2012 and its carrying amount at the end of the year would be €3,464 (€3,000 + €464). However if at the end of the year the cash flow expected to be generated by the instrument had increased to €4,250 (still to be received at the end of 2013), an adjustment to the asset would be made as set out at 5.2.1 above. Accordingly, its carrying amount would be increased to €3,681 (€4,250 discounted over one year at 15.5%) and a further €217 income would be recognised in profit or loss. Of course, there would need to be a substantive and supportable basis for revising the cash flow estimates.