Intermediate Accounting II Otto Chang Professor of Accounting Chapter 14 Intermediate Accounting II Otto Chang Professor of Accounting Chang, Otto

Types of Bonds Secured and Unsecured (debenture) Bonds Term, Serial, Callable Bonds Convertible (into other securities) Bonds, Commodity-Backed (Asset-Linked) Bonds, Deep Discounted (Zero Interest Debenture) Bonds Registered and Bearer (Coupon) Bonds Income and Revenue Bonds: interest paid from income or special revenues Chang, Otto

Valuation of Bonds Payable Face value, par value, principal Amount, maturity value Stated, coupon, nominal rate effective yield, market rate Discount: when stated rate is less than effective yield Premium: when stated is higher than effective yield Chang, Otto

Accounting for Bonds Issuance Between interest dates, issued at premium Cash 104 Premium on Bonds Payable 3 Bonds Payable 100 Bond Interest Expense 1 Amortization of Premium or Discount Straight-line over life of the bonds Effective interest method Chang, Otto

Effective Interest Method Example: 10% 5-yr $10,000 bonds sold at $108,530 to yield 6% Cash Interest Premium Carrying Date Paid Expense Amortized Value 1/1/98 $108,530 7/1/98 $4,000 $3,256 $744 107,786 1/1/99 4,000 3,234 766 107,020 7/1/99 4,000 3,211 789 106,231 Interest expense = carrying value x yield rate Premium amortized = cash paid - interest expense Chang, Otto

Journal entries To record bond issuance on 1/1/98 Cash $108,530 Premium on B/P 8,530 Bonds payable 100,000 To record payment of interest on 7/1/98 Interest Expense $3,256 Premium on B/P 744 Cash $4,000 Chang, Otto

Classification of Discount or Premium Discount and Premium on B/P are contra accounts. They should be reported as a direct deduction from or addition to the face amount of the bonds on the balance sheet: Long-term Liabilities: Bonds Payable XXXX (face amount) Less: Discount on B/P XX Net Carrying amount of B/P Chang, Otto

Costs of Issuing bonds Costs such as printing, legal and accounting fee, commissions, and promotion fees can be deferred and amortized over the life of bonds. Example: Cash 103,000 Unamortized Bond Issue Cost 2,000 Premium on Bonds Payable 5,000 Bonds Payable 100,000 Chang, Otto

Extinguishment of Long-Term Debts The difference between the requisition cost and the net carrying amount of bonds (net of unamortized issue cost) is extraordinary gain or loss. Example: Bonds Payable $800,000 Loss on Redemption 32,000 Discount on Bonds Payable 14,400 Unamortized Bonds Issue Cost 9,600 Cash 808,000 Chang, Otto

In-Substance Defeasance Placing purchased securities in an irrevocable trust, the principal and interest of which are pledged to pay off own debt Question: is the debt extinguished? Answer: No The debtor is not legally released from being the primary obligator under the liability, either judicially or by the creditor Chang, Otto

Notes Payable Accounting similar to bonds payable. Notes issues for cash and other rights or for property, goods, and services : record N/P and related discount to reflect fair value exchanged Discount calculated at the imputed interest rate, which is usually the incremental borrowing rate Chang, Otto

Off-Balance-Sheet Financing Project financing arrangement A and B form a new entity C C borrows funds to construct a plant to provide goods or services to A & B C’s debt is guaranteed by A & B through unconditional purchase obligations such as take-or-pay (for goods) or through-put (for service) contract Advantage: A & B report no liability FASB’s requirement: footnote disclosure Chang, Otto

Other Disclosure Required for Long-Term Debts Future payment for sinking fund and maturity amount of long-term debts during the next five years Chang, Otto

Accounting for Troubled Debts Impairment: loss probable before maturity Journal entries: Creditor Debtor Bad Debt Expense xxx No entry Allowance for Bad Debt xxx Loss = PV* of revised future cash flow- carrying value * discounted at historical rate Interest revenue should be computed based on new carrying amount

Impairment: Example On 12/31/93 received a 5-year, non-interest-bearing note to yield at 10% On 12/31/95, it is determined that only $300,000 can be collected at maturity Loss recognized by creditor on 12/31/95: PV of future cash $300.000 x 0.7512 = $225,396 Less: carrying value on 12/31/95 375,657 Bad debt expense recognized ($150,261)

Restructuring at Maturity Date Settlement of debt at less than carrying value Example: debtor gave land (book value $21,000, FMV=$16,000) to settle N/P of $20,000 Creditor Debtor Land 16,000 N/P 20,000 B/D allowance 4,000 Loss on land 5,000 N/P 20,000 Land 21,000 Gain on debt 4,000

Continuation of Debt with Modified Terms Example: reduction in interest rate or principal, extension of maturity date, forgiving of accrued interest Creditor: Recognize loss based on PV of restructured cash flow. Recognize interest revenue based on new recorded value and original effective rate.

Modification of Terms-continued Debtor’s accounting treatment: Carrying amount of debt is less than revised future cash flow: Recognize no gain on restructure. Determine new effective interest rate to be used in recording interest expense. Carrying amount of debt is greater than total future cash flows: Recognize gain on restructure. Recognize no interest expense over the remaining life of the debt.

Example I: No Gain for Debtor On 12/31/98 a bank restructures a $10,500,000 loan issued at par (interest paid to date) by: reducing the principal to $9,000,000 extending the maturity date from 12/31/98 to 12/31/2002 (4 years later) reducing the interest rate from 12% to 8% Future cash flow ($9,000,000 + $2,880,000*) > $10,500,000 *2,880,000 = $9,000,000 x 8% x 4 Chang, Otto

Debtor’s Accounting Treatment The new effective rate is 3.46613% Journal entry to record payment of interest expense on 12/31/1999 is: N/P (reduction of principal) 356,056 Interest Expense 363,944* Cash 720,000 *10,500,000 x 3.46613% Journal entry to record payment of principal Notes Payable 9,000,000 Cash 9,000,000 Chang, Otto

Creditor’s Accounting Treatment The PV of Future Cash Flow is $7,906,572 To record Bad debt expense on 12/31/98 Bad Debt Expense 2,593,428* Allowance for B/D 2,593,428 * $10,500,000 - $7,906,572 To record Interest revenue on 12/31/99 Cash 720,000 Allowance for B/D 228,789 Interest Revenue 948,789* * 7,906,572 x 12% Chang, Otto

Example 2: Gain for Debtor On 12/31/98 a bank restructures a $10,500,000 loan issued at par (interest paid to date) by: reducing the principal to $7,000,000 extending the maturity date from 12/31/98 to 12/31/2002 (4 year later) reducing the interest rate from 12% to 8% Future cash flow ($7,000,000 + $2,240,000*) < $10,500,000 by $1,260,000 *2,240,000 = 7,000,000 x 8% x 4 Chang, Otto

Accounting Treatment for Debtor Recognize extraordinary gain of $1,260,000 Notes Payable 1,260,000 Gain on Restructuring of Debt 1,260,000 Record payment of “interest expense” Notes Payable 560,000 Cash 560,000 Record payment of principle on 12/31/2002 Notes Payable 7,000,000 Cash 7,000,000 Chang, Otto

Accounting Treatment for Creditor PV of future cash flow is $6,149,556 Record bad debt expense on 12/31/98 Bad Debt Expense 4,350,444 Allowance for B/D 4,350,444 Record interest revenue on 12/31/99 Cash 560,000 Allowance for B/D 177,947 Interest Revenue 737,947* * $6,149,556 x 12% Chang, Otto