Chapter 14: Long Term Liabilities Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 14: Long Term Liabilities Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas

Part 1: Bonds Payable

Long-Term Debt: General Long term debt consists of probable future sacrifices. It has various covenants or restrictions for the protection of both lenders and borrowers. The indenture or agreement incorporates the terms of the issue and restrictions. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Issuing Bonds Bonds are the most common type of long term debt. They are usually issued in denominations of $1,000. 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 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Select Types of Bonds Secured and unsecured bonds: bonds secured by collateral (real estate, stocks) Serial bonds: mature in installments Callable bonds: give issuer to call and retire debt prior to maturity Convertible bonds: can be converted into other corporate securities for a specified time after issue Bearer bonds: are freely transferable by current owner. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bond Issues: Parties to the Contract lend cash Issuer of Bonds Bondholders 3. Redemption of Face Value 2. Periodic interest 1. Bond Certificate 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Valuation of Bonds: Determining Bond Prices The price of a bond issue is determined by: the present value of the annuity of interest payments (at the contractual rate of interest), and the present value of the redemption (face) value, both discounted at the market rate of interest at issue date. Interest payments by borrower are calculated as: Face value of bond issue * contractual interest rate (as specified in the bond indenture) 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Valuation of Bonds: Determining Bond Prices - Example Given: Face value of bond issue: $100,000 Term of issue: 5 years Contractual interest rate: 9% per year, payable annually end of the year Market rate of interest: 11% Determine the issue price of the bonds. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Valuation of Bonds: Determining Bond Prices - Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 $9,000 interest $100,000 face value Redemption at maturity ==> Interest = $100,000 * 9% per year contractual rate 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Valuation of Bonds: Determining Bond Valuation of Bonds: Determining Bond Prices - Present Value of Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 $9,000 interest Discount at market rate, 11% $9,000 * 3.69590 $ 33,262 $100,000 Discount at market rate, 11% $100,000 * 0.59345 $ 59,345 plus =$92,607 is the issue price 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bond Issue Pricing: Concept Relationship Relationship Rationale between between contractual rate Issue Price and market rate and Face Value CR = Mkt Rate Issue Price = F.V Market rate is the same as Bond rate CR < Mkt Rate Issue Price < F.V. Issuer offers a discount to b/holder to compensate for lower bond interest CR > Mkt Rate Issue Price > F.V. Issuer gets a premium for higher bond interest 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Discount on Bonds Payable: Concept The discount is amortized (spread over the bond term) either by the straight line method or the effective interest method. The amortized discount on bond issue is added to the interest paid in cash during the interest period. Interest expense is recognized as follows: Cash paid for interest: $XXX Add: Discount amortized: $XXX Interest expense recognized: $XXX 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Premium on Bonds Payable: Concept The premium is amortized (spread over the bond term) either by the straight line method or the effective interest method. The amortized premium on bond issue is subtracted from the interest paid in cash during the interest period. Interest expense is recognized as follows: Cash paid for interest: $XXX Less: Premium amortized: $XXX Interest expense recognized: $XXX 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

A Note on Amortization Methods The straight line method allocates the same amount of discount (or premium) to each interest period. The effective interest method allocates the discount or premium in increasing amounts over the bond term (see following examples) However, the total discount or premium amortized is the same under both methods. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bonds Payable: Face Value, Discount, and Carrying Value - Concept 1. Face value remains the same throughout the bond term. 2. Unamortized discount gradually decreases over the bond term. 3. Carrying value gradually increases and is equal to face value at redemption. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bonds Payable: Face Value, Premium, and Carrying Value - Concept 1. Face value remains the same throughout the bond term. 2. Premium unamortized gradually decreases over the bond term. 3. Carrying value gradually decreases and is equal to face value at redemption. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bonds Issued at Par on Interest Date Given: (Fiscal year is calendar year) Face value of bonds issued: $100,000 Issue Price: $100,000 Market Rate: 10% Contractual Rate: 10% Date of issue: January 1, 2000 Interest dates: July 1 and Jan 1 Give the journal entries for issue and payment of interest. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bonds Issued at Par on Interest Date January 1, 2000 (Issue): Cash $100,000 Bonds Payable $100,000 July 1, 2000 (Interest Payment): Interest Expense $ 5,000 Cash $ 5,000 December 31, 2000 (Interest Accrual): Interest Expense $ 5,000 Interest Payable $ 5,000 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bonds Issued at a Premium on Interest Date: Straight Line Amortization Given: (Fiscal year is calendar year) Face value of bonds issued: $ 100,000 Issue Price: (issue at 108.53) $ 108,530 Market Rate: 6% Contractual Rate: 8% Date of issue: January 1, 2000 Interest dates: July 1 and Jan 1 Term of issue: 5 years Give the journal entries for issue and interest payment. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bonds Issued at a Premium on Interest Date: Straight Line Amortization January 1, 2000 (Issue): Cash $108,530 Bonds Payable $100,000 Premium on Bonds Payable $ 8,530 July 1, 2000 (Interest Payment): Interest Expense $ 3,147 Premium on Bonds Payable $ 853 Cash $ 4,000 Note: Premium amortized = $ 8,530 / 10 payments = $ 853 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount on Interest Date: Straight Line Amortization Given: (Fiscal year is calendar year) Face value of bonds issued: $ 100,000 Issue Price: $ 92,278 Market Rate: 10% Contractual Rate: 8% Date of issue: January 1, 2000 Interest dates: July 1 and Jan 1 Term of issue: 5 years Give the journal entries for issue and interest payment. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount on Interest Date: Straight Line Amortization January 1, 2000 (Issue): Cash $ 92,278 Discount on Bonds Payable $ 7,722 Bonds Payable $100,000 July 1, 2000 (Interest Payment): Interest Expense $ 4,772 Discount on Bonds Payable $ 772 Cash $ 4,000 Note: Discount amortized = $ 7,722 / 10 payments = $ 772 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Bond Issued between Interest Dates: Concept Bonds may be 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. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Premium between Interest Dates: Straight Line Amortization Given: (Fiscal year is calendar year) Face value of bonds issued: $ 100,000 Issue Price: (issue at 108.53) $ 108,530 Market Rate: 6% Contractual Rate: 8% Date of issue: March 1, 2000 Interest dates: July 1 and Jan 1 Term of issue: 5 years Give the journal entries for issue and interest payment. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Premium between Interest Dates: Straight Line Amortization March 1, 2000 (Issue): Cash $109,863 Bonds Payable $100,000 Premium on Bonds Payable $ 8,530 Bond Interest Expense (2 months) $ 1,333 July 1, 2000 (Interest Payment): Bond Interest Expense $ 3,431 Premium on Bonds Payable $ 569 Cash $ 4,000 Note: Premium amortized = ($853 / 6) * 4 months 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount between Interest Dates: Straight Line Amortization Given: (Fiscal year is calendar year) Face value of bonds issued: $ 100,000 Issue Price: $ 92,278 Market Rate: 10% Contractual Rate: 8% Date of issue: March 1, 2000 Interest dates: July 1 and Jan 1 Term of issue: 5 years Give the journal entries for issue and interest payment. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount between Interest Dates: Straight Line Amortization March 1, 2000 (Issue): Cash $ 93,611 Discount on Bonds Payable $ 7,722 Bonds Payable $100,000 Bond Interest Expense (2 mo) $ 1,333 July 1, 2000 (Interest Payment): Bond Interest Expense $ 4,515 Discount on Bonds Payable $ 515 Cash $ 4,000 Note: Discount amortized = ($ 772 / 6) * 4 months = $ 515 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount on Interest Date: Effective Interest Amortization Given: (Fiscal year is calendar year) Face value of bonds issued: $ 100,000 Issue Price: $ 92,278 Market Rate: 10% Contractual Rate: 8% Date of issue: January 1, 2000 Interest dates: July 1 and Jan 1 Term of issue: 5 years Give the journal entries for issue and interest payment. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount on Interest Date: Effective Interest Amortization Effective interest method: Amortization schedule Date Interest Cash Discount Carrying Expense Paid Amortized Value (end) 1.1.00 --- --- --- $ 92,278 July 1 $4,614 $4,000 $614 $ 92,892 1.1.01 $4,645 $4,000 $645 $ 93,537 Interest expense = Carrying value * (1/2) Mkt rate at Beginning Discount amortized = Interest expense less cash paid 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Bonds Issued at a Discount on Interest Date: Effective Interest Amortization January 1, 2000 (Issue): Cash $ 92,278 Discount on Bonds Payable $ 7,722 Bonds Payable $100,000 July 1, 2000 (Interest Payment): Bond Interest Expense $ 4,614 Discount on Bonds Payable $ 614 Cash $ 4,000 Note: Discount amortized = $4,614 less $4,000 = $614 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Classification of Discount on Bonds Payable Discount on bonds payable is a contra liability account and is shown as: Bonds Payable (face value) : $ XXX less: Unamortized Discount : ($ XX) Bonds Payable (carrying value): $ XXX 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Classification of Premium on Bonds Payable Premium on bonds payable is an adjunct account and is shown as: Bonds Payable (face value) : $ XXX Add: Unamortized Premium : $ XX Bonds Payable (carrying value): $ XXX 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Accounting for the Costs of Issuing Bonds Costs of issue must be amortized over the life of the bond issue. Even though both straight line and effective interest methods are acceptable, the straight line method is used in most cases. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Extinguishment of Debt When debt is extinguished (paid), any premium or discount on bond issue must be amortized up to the date of extinguishment, and any bond issue costs must be amortized up to date of extinguishment. Any gain or loss from extinguishment of debt is treated as an extraordinary item. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

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. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Extinguishment of Debt: Example Bonds Payable $800,000 Loss on Extinguishment $ 32,000 Discount on Bonds $ 14,400 Unamortized Bond Issue Costs $ 9,600 Cash $ 808,000 Note: The loss is a balancing figure and an extraordinary item. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Part 2: Long-Term Notes Payable

LT Notes Payable and Bonds Payable: A Comparison Notes payable and bonds payable are similar in that: both have fixed maturity dates both have either stated or implicit rates Like a bond, a note payable is valued at the present value of its future interest payments and the principal (at maturity date.) 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Note Issues A note may be issued at: face value or other than its face value When issued at other than its face value, a note may have: no interest specified (zero interest), or an interest rate less than the market rate (discount results) A discount is amortized over the note term under the effective interest method 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

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 See next slide for example 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Note Issued for Cash and Other Rights Given: Issuer gives a 5 year, $100,000 note payable to Recipient company on 1.1.2000. 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. Recipient company buys $ 50,000 of merchandise (market price) on April 14, 2000. Journalize in Issuer’s books. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Note Issued for Cash and Other Rights Issuer of Note Recipient of Note Issues a 5 yr, $100,000, zero % interest note. Market rate is 10% Recipient (buyer) has special buying rights at below market prices Gives issuer cash, $100,000 Issuer records: 1. Discount on the note ( $37, 908), and 2. Unearned Revenue ($37,908) toward the special buying rights of the recipient of note 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Note Issued for Cash and Other Rights Books of the Issuer (1.1.2000): Cash $100,000 Discount on Note Payable $ 37,908 Note Payable $100,000 Unearned Revenue $ 37,908 The discount is amortized over the term of note. The (unearned) revenue is recognized as sales are made. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Books of the Issuer of Note Note interest expense $ 3,105 Discount on Note Payable $ 3,105 ($100,000 - $ 37,908) * 10% * (1/2) = $3,105 Cash (or A/Rec: Recipient) $ 46,209 Unearned Revenue $ 3,791 Sales Revenue $ 50,000 (Revenue recognized = $ 37,908 * ( $50,000 / $500,000) 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

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. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Accounting for Troubled Debt Chapter 14: Appendix Accounting for Troubled Debt

Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.) Accounting Issues In troubled debt cases, two important issues emerge: When should a loss be recognized? What is the amount of loss to be recognized? See next slide for a summary of key terms. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Troubled Debt: Key Terms Impairment Restructuring Probable loss: creditor, unable to collect principal and interest. Creditor grants a concession to debtor due to debtor’s financial difficulties. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Troubled Debt: Key Terms Restructuring Creditor grants a concession to debtor due to debtor’s financial difficulties. Settlement Modification of Terms Debtor transfers equity interest or non-cash assets to creditor 1. Reduction of principal 2. Reduction of interest rate 3. Extension of maturity date 4. Reduction of accrued interest 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Gain or Loss: Debtor and Creditor - Settlement Gain = excess of carrying amount of payable over fair value of assets transferred to creditor The gain is extraordinary Recognize loss or gain on disposition of non-cash assets transferred to creditor Loss = excess of loan receivable over fair value of assets received from debtor The loss is ordinary and is charged to Allowance for Doubtful accounts 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Modification of Terms: No Gain to Debtor (1 of 2) Debtor recognizes loss as follows: Total (undiscounted) cash outflows after restructuring less carrying value of debt before restructuring Note 1: The post-restructuring cash outflows may be higher due to an extension of the maturity date. Note 2: The cash flows are NOT discounted. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Modification of Terms: No Gain to Debtor (2 of 2) Creditor recognizes loss as follows: Total (discounted) cash outflows after restructuring less carrying value of debt before restructuring Note: The creditor must discount principal and interest receipts at the historical (original) effective rate of the loan. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Modification of Terms: Gain to Debtor Debtor recognizes gain as follows: Total (undiscounted) cash outflows after restructuring less total carrying value of debt before restructuring Note: The gain is reported as an extraordinary item. 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

Modification of Terms: Gain to Debtor Creditor recognizes loss as follows: Total (discounted) cash outflows after restructuring less total carrying value of debt before restructuring Note: The loss is reported as an ordinary loss (Bad Debts Expense) 11/8/2018 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

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