Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology 2

Long-Term Financial Liabilities C H A P T E R 15 Long-Term Financial Liabilities

Learning Objectives 1. Describe the formal procedures associated with issuing long-term debt. 2. Identify various types of long-term debt. 3. Explain the initial measurement of bonds/notes at date of issuance. 4. Apply the methods of bond discount and premium amortization.

Learning Objectives 5. Value bonds and consideration in special situations. 6. Describe the accounting procedures for the extinguishment of debt. 7. Explain the issues surrounding off-balance-sheet financing arrangements. 8. Indicate how long-term debt is presented and analysed.

Learning Objectives Account for impairments on notes and loans receivable. (Appendix 15A) Distinguish between and account for debt restructurings resulting in extinguishment versus debt continuation. (Appendix 15A)

Long-Term Financial Liabilities Measurement and Valuation Bonds/Notes issued at par Discounts and premiums Deep discount/zero interest bonds/notes Special situations Issuance costs Nature of Long-term Debt Bonds Notes payable Types of bonds/notes Bond ratings Extinguishment/Derecognition Repayment prior to maturity date Exchange of debt instruments Defeasance Recognition and Presentation Off-balance-sheet financing Presentation Long-term debt Note disclosures Appendix 15A-Troubled Debt Impairment of Loans/Notes receivable Troubled debt restructuring Perspectives

Issuing Long-Term Debt Obligations not payable within one year, or one business operating cycle—whichever is longer Examples include: Bonds payable Long-term notes Mortgages Pension liabilities Lease liabilities Often with restrictive covenants (terms) attached

Bonds Most common type of long-term debt A bond indenture is a promise (by the lender to the borrower) to pay: a sum of money at the designated date, and periodic interest at a stipulated rate on the face value A bond issue may be sold: either through an investment banker, or by private placement

Notes Payable Similar in nature to bonds Require repayment of principal at a future date Require periodic interest payments Difference is notes do not normally trade on public markets Accounting for bonds and notes is the same in many respects

Types of Long-Term Debt Bearer bonds: are freely transferable by current owner Secured and unsecured debt: secured by collateral (real estate, stocks) Serial bonds: mature in instalments Callable bonds: give issuer right to call and retire debt prior to maturity Income and Revenue bonds: interest payments tied to some form of performance Deep-discount bonds: little or no interest payments; sold at substantial discount Convertible bonds: can be converted into other corporate securities for a specified time after issue

Bond Valuation: Determining Bond Prices Price of a bond issue is determined by finding the present value (PV) of future cash flows: the PV of the interest payment annuity (at the stated or coupon rate of interest), plus the PV of the redemption (face, par) value, both discounted at the market (yield) rate of interest in effect at issue date When market rate  stated rate  bond sells at discount When market rate  stated rate  bond sells at premium

Bond Valuation: Bond Price Calculation Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated interest rate: 9% per year, payable end of the year Market rate of interest: 11% Determine the issue price of the bonds.

Bond Valuation: Bond Price Calculation Year 1 Year 2 Year 3 Year 4 Year 5 $9,000 Interest annuity $100,000 Face Value Discount the future cash flows using the market (yield) rate of interest

Bond Valuation: Bond Price Calculation Year 1 Year 2 Year 3 Year 4 Year 5 $9,000 Discount at market rate, 11% $9,000 x 3.69590 $33,263 $100,000 Discount at market rate, 11% $100,000 x 0.59345 $ 59,345 plus =$92,608 is the issue price

Entries for the Issuance of Bonds Sold at Par Cash 1,000 Bonds Payable 1,000 Sold at a Premium Cash 1,100 Premium on Bonds 100 Bonds Payable 1000 Sold at a Discount Cash 900 Discount on Bonds 100 Bonds Payable 1000

Amortizing the Bond Premium/Discount A premium effectively decreases the annual interest expense for the corporation The discount effectively increases the annual interest expense for the issuing corporation

Amortizing the Bond Premium/Discount Two methods available for amortization Straight line allocates the same amount of discount (or premium) to each interest period Effective interest allocates the discount or premium in increasing amounts over the bond term

Amortizing the Bond Premium/Discount The total discount or premium amortized is the same under both methods The straight-line method of amortizing is acceptable under GAAP only if the results are not materially different from those produced by using the effective interest method

Straight-Line Method—Discount Given: Face Value = $800,000 Discount = $24,000 Coupon Rate = 10% Bond Maturity = 10 years The annual discount amortization = $24,00010 years = $2,400 The entry to record the annual discount amortization would be: Interest Expense 2,400 Discount on Bonds 2,400

Straight-Line Method—Premium Given: Face Value = $800,000 Premium = $24,000 Coupon Rate = 10% Bond Maturity = 10 years The annual premium amortization = $24,00010 years = $2,400 The entry to record the annual premium amortization would be Premium on Bonds 2,400 Interest Expense 2,400

Effective Interest Method Considers the change in interest costs as the life of the bonds increases Uses the market rate at the date of sale to calculate the amortization amount over the life of the bond

Effective Interest Method Calculation

Effective Interest Method The journal entry to record the bond issuance is: Cash 92,278 Discount on Bonds Payable 7,722 Bonds Payable 100,000

Effective Interest Method The journal entry for first semi-annual payment is: Bond Interest Expense 4,614 Discount on Bonds Payable 614 Cash 4,000

Effective Interest Method Calculation

Effective Interest Method The journal entry to record the bond issuance is: Cash 108,530 Premium on Bonds Payable 8,530 Bonds Payable 100,000

Effective Interest Method The journal entry for first semi-annual payment is: Bond Interest Expense 3,256 Premium on Bonds Payable 744 Cash 4,000

Balance Sheet Presentation Discount on bonds payable is a contra account: Bonds Payable (face value): $ XXX Less: Unamortized Discount : ($ XX) Bonds Payable (carrying value): $ XXX Premium on bonds payable is an adjunct account: Bonds Payable (face value) : $ XXX Add: Unamortized Premium : $ XX Bonds Payable (carrying value): $ XXX

Bonds Issued Between Interest Dates Interest, for the period between the issue date and the last interest date, is collected with the issue price of the bonds At the specified interest date, interest is paid for the entire interest period (semi-annual or annual) Premium or discount is also amortized from the date of sale of bonds to the end of the interest period

Deep Discount/Zero-Interest-Bearing Bonds/Notes If issued for cash PV = cash received by issuer Interest rate is the rate that causes the PV (of future cash flows) to equal cash received Difference between face amount and PV is the discount Amortized over life of the note

Deep Discount/Zero-Interest-Bearing Bonds/Notes Example: Jeremiah Company 10,000 3-year zero-interest-bearing note issued Cash received at issuance: $7721.80 Discount equal to: $10,000 Less: Cash 7,722 $ 2,278 Implied interest rate therefore: 9%

Note Issued for Cash and Other Rights Sometimes, an issuer (borrower) of a note payable with below-market interest gives the recipient of the note (lender) additional buying rights Then, the borrower is also the seller and the lender is also the buyer The borrower must record both: a discount on the note, and unearned revenue Example

Note Issued for Cash and Other Rights Given: Issuer gives a 5 year, $100,000 note payable to recipient on January 1st The note is zero-interest bearing The market rate is 10% Recipient company has special rights to buy $500,000 of merchandise from issuer company at below market prices Journalize in issuer’s books

Note Issued for Cash and Other Rights Books of the Issuer: Cash 100,000 Discount on Note Payable 37,908 Note Payable 100,000 Unearned Revenue 37,908 PV of 100,000 at 10%, (n=5) = 62,902 Discount: (100,000 – 62,902) = 37,908 The discount is amortized over the term of note The (unearned) revenue is recognized as sales are made

Note Issued for Cash and Other Rights Assume that the recipient purchased $50,000 worth of merchandise from the issuer. The journal entry to record that revenue: Cash (or A/R: Recipient) 46,209 Unearned Revenue 3,791 Sales Revenue 50,000 (Revenue recognized = $ 37,908 x ( $50,000/$500,000) = $3,791

Notes Issued for Property, Goods, and Services Notes issued and payment is asset other than cash PV of debt at fair value of the property, goods or services if: No stated interest rate Stated interest rate is unreasonable Material difference exists between the stated value of note and market value of the asset being exchanged Any discount or premium amortized over life of the note

Bond Issue Costs Those costs incurred to physically issue the bonds e.g., costs paid to the broker, legal costs Not part of any premium or discount Debited to a deferred charge Amortized over the life of the bond, using straight line method

Extinguishment of Debt When debt is paid out prior to maturity Reacquisition, requires gain or loss to be recorded May be for full amount of debt, or a portion At the time of reacquisition all outstanding premiums, discounts, and issue costs are amortized to the date of reacquisition Any gain or loss from the reacquisition is reported with other capital gains/losses (does not qualify as an extraordinary item)

Extinguishment of Debt Generally, when bonds are reacquired they are cancelled If they are not cancelled, they are considered treasury bonds May be resold or subsequently cancelled Treasury bonds are reported as a deduction from Bonds Payable on the balance sheet Refunding of bonds: when a bond issue is called in and replaced with a new issue (at a lower rate of interest)

Extinguishment of Debt: Example Given: Existing debt: $800,000 Called and canceled at: $808,000 Unamortized discount: $ 14,400 Unamortized bond issue costs: $ 9,600 Note: Both discount and bond issue costs have been amortized up to the date of cancellation of debt. Give the journal entry for the extinguishment.

Extinguishment of Debt: Example Bonds Payable 800,000 Loss on Redemption of Bonds 32,000 Discount on Bonds 14,400 Unamortized Bond Issue Costs 9,600 Cash 808,000

Defeasance Sufficient funds set aside (i.e. trust) to pay off principal and interest on the debt “Legal defeasance” occurs when the debt holder no longer has claim on the assets of the original issuer Trust held responsible for repayment “In-substance defeasance” occurs when the debt holder is not aware of the trust arrangement CICA Handbook, Section 3855 (proposed) will deal with whether or not this is deemed an extinguishment of debt

Off-Balance-Sheet Financing Off-balance-sheet financing represents borrowing arrangements that are not recorded The amount of debt reported in the balance sheet does not include such financing arrangements The objective is to improve certain financial ratios (such as debt-equity ratio) In project financing arrangements, companies form a new entity and borrow through that entity The debt appears on the books of the new entity, and not on those of the parent companies

Off-Balance-Sheet Financing Different forms of off-balance-sheet financing Non-consolidated subsidiaries Special Purpose Entities (SPE) or Variable Interest Entities (VIE) Operating Leases

Presentation of Long-Term Debt Current versus long-term Debt to be refinanced treated as long-term Debt versus equity Dependent on nature of the instrument Classification of Discount and Premium Discount – contra account Premium – adjunct account Both reported within liability

Note Disclosure Include: Nature of the liability Maturity date Interest rate Call provision Conversion privileges Any restrictions imposed Assets designated or pledged as security

Long-Term Debt Analysis Debt to Total Assets: Total debt Total assets Level or percentage of assets that is financed through debt Times Interest Earned: Income before income taxes and interest Interest Expense Measures ability to meet interest payments

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