1. Long-Term Liabilities and Receivables C hapter 14 COPYRIGHT © 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University

2. 2 1.Debt financing may be the only available source of funds. 2.Debt financing may have a lower cost. 3.Debt financing offers an income tax advantage. 4.The voting privilege is not shared. 5.Debt financing offers the opportunity for leverage. Reasons for Issuance of Long-Term Liabilities

3. 3 1.A bond is a type of note in which a company agrees to pay the holder the face value at the maturity date and usually to pay interest periodically at a specified rate on the face value. 2.A bond indenture is a document (contract) that defines the rights of the bondholders. Bonds

4. 4  Debenture bonds  Mortgage bonds  Registered bonds  Coupon bonds  Zero-coupon bonds  Callable bonds  Convertible bonds  Serial bonds Types of Bonds

5. 5 1.The face (or par) value is the amount that the issuer agrees to pay at maturity. 2.The stated, face, nominal, or contract rate is the rate at which the issuer of the bond agrees to pay interest each period until maturity. 3.The yield (effective rate) is the market rate at which the bonds are actually sold. Bond Terminology

6. 6 1.It must receive approval from regulatory authorities such as the Securities and Exchange Commission. 2.The company must set the terms of the bond issue, such as the contract rate and the maturity date. 3.It must make a public announcement of its intent to sell the bonds on a particular date and print the bond certificates. Steps a Company Must Follow When It Issues Bonds

7. 7Straight-LineMethodStraight-LineMethod

8. 8 Jet Company sells bonds for $92,976.39 on January 1, 2010. The bonds have a face value of $100,000 and a 12% stated annual interest rate. Interest is paid semiannually and the bonds mature on December 31, 2014. Cash92,976.39 Discount on Bonds Payable7,023.61 Bonds Payable100,000.00 ContinuedContinued Bonds Issued at a Discount

9. 9 Jet Company records the first interest payment on June 30, 2010. Interest Expense6,702.36 Discount on Bonds Payable702.36 Cash6,000.00 $6,000 + $702.36 $7,023.61 ÷ 10 $100,000 × 0.12 × 1/2 Straight-Line Method Bonds Issued at a Discount

10. 10 After this second entry, the long-term liabilities section of Jet’s December 31, 2010 balance sheet would include the following: Bonds payable$100,000.00 Less: Discount on bonds payable (5,618.89) $ 94,381.11 $7,023.61 – $702.36 – $702.36 Straight-Line Method Bonds Issued at a Discount

11. 11 Jet Company sold the five-year bonds on January 1, 2010 for $107,721.71. Interest is paid semiannually. Cash107,721.71 Bonds Payable100,000.00 Premium on Bonds Payable7,721.71 ContinuedContinued Straight-Line Method Bonds Issued at a Premium

12. 12 The first interest payment is made on June 30. Interest Expense ($6,000 – $772.17)5,227.83 Premium on Bonds Payable772.17 Cash ($100,0000 × 0.12 × 1/2)6,000.00 ContinuedContinued Straight-Line Method Bonds Issued at a Premium $7,721.71 ÷ 10

13. 13 After this second entry, the long-term liabilities section of Jet’s December 31, 2010, balance sheet would include the following: Bonds payable$100,000.00 Add: Premium on bonds payable 6,177.37 $106,177.37 $7,721.71 – $772.17 – $772.17 Straight-Line Method Bonds Issued at a Premium

14. Straight-Line Discount Amortization Schedule 14

15. Straight-Line Premium Amortization Schedule 15

16. 16 Effective Interest Method

17. 17 Jet Company desires to sell $100,000 of five-year bonds paying semiannual interest with a stated rate of 12%. The current effective interest rate is 14%. Present value of principal: $100,000 × 0.508349$ 50,834.90 Present value of interest: $6,000 × 7.023582 42,141.49 Selling price$ 92,976.39 Selling value$100,000.00 Face value (92,976.39) Discount$ 7,023.61 Determining the Selling Price

18. 18 Jet Company desires to sell $100,000 of five-year bonds paying semiannual interest with a stated rate of 12%. The current effective interest rate is 14%. Present value of principal: $100,000 × 0.613913$ 61,391.30 Present value of interest: $6,000 × 7.721735 46,330.41 Selling price$ 107,721.71 Selling value$ 107,721.71 Face value (100,000.00) Discount$ 7,721.71 Determining the Selling Price

19. 19 Using the straight-line method, interest expense is the same every year—which is not realistic when a premium or discount is involved. Instead, the effective-interest method allows for a stable interest rate per year. Effective Interest Method

20. 20 Jet Company sells bonds for $92,976.39 on January 1, 2010. The bonds have a face value of $100,000 and a 12% stated annual interest rate. Interest is paid semiannually and the bonds mature on December 31, 2014. Cash92,976.39 Discount on Bonds Payable7,023.61 Bonds Payable100,000.00 ContinuedContinued Issuing Bonds at a Discount Effective Interest Method

21. 21 $100,000 × 0.12 × 1/2 Jet Company records the first interest payment on June 30, 2010. Interest Expense6,508.35 Discount on Bonds Payable508.35 Cash6,000.00 $92,976.39 × 0.14 × 1/2 $6,508.35 – $6,000.00 Issuing Bonds at a Discount Effective Interest Method

22. 22 $100,000 × 0.12 × 1/2 Jet Company records the second interest payment on December 31, 2010. Interest Expense6,543.93 Discount on Bonds Payable543.93 Cash6,000.00 ($92,976.39 + $508.35) × 0.14 × 1/2 $6,543.93 – $6,000.00 Issuing Bonds at a Discount Effective Interest Method

23. 23 Effective Interest Discount Amortization Schedule

24. 24 Jet Company sold bonds on January 1, 2010, for $107,721.71. Interest is paid semiannually. Cash107,721.71 Bonds Payable100,000.00 Premium on Bonds Payable7,721.71 ContinuedContinued Issuing Bonds at a Premium Effective Interest Method

25. 25 The first interest payment is made on June 30. Interest Expense5,386.09 Premium on Bonds Payable613.91 Cash 6,000.00 ContinuedContinued Issuing Bonds at a Premium Effective Interest Method $107,721.71 × 0.10 × 1/2 $6,000.00 – $5,386.09 $100,000 × 0.12 × 1/2

26. 26 $100,000 × 0.12 × 1/2 Jet Company records the second interest payment on December 31, 2010. Interest Expense5,355.39 Premium on Bonds Payable644.61 Cash6,000.00 ($107,721.71 – $613.91) × 0.10 x 1/2 $6,000.00 – $5,355.39 Issuing Bonds at a Premium Effective Interest Method

27. 27 Effective Interest Premium Amortization Schedule

28. 28 On January 1, 2010 Bergen Company issues 10- year bonds with a face value of $500,000 at 104. Expenditures connected with the issue totaled $8,000. Cash ($520,000 – $8,000)512,000 Deferred Bond Issue Costs8,000 Bonds Payable500,000 Premium on Bonds Payable20,000 0.04 × $500,000 Bond Issue Costs

29. The deferred bond issue costs of $800 are amortized to bond interest expense each year over the 10-year life of the bonds. Bond Issue Costs 29

30. 30 McAdams Company issues $200,000 of 10%, five- year bonds on October 1, 2010, for $185,279.87. Interest on these bonds is payable each October 1 and April 1. Cash 185,279.87 Discount on Bonds Payable14,720.13 Bonds Payable200,000.00 ContinuedContinued Accruing Bond Interest

31. 31 At the end of the fiscal year, December 31, 2010, an adjusting entry is required to record interest for three months (assume straight-line amortization). Interest Expense5,736.01 Discount on Bonds Payable736.01 Interest Payable5,000.00 ($14,720.13 ÷ 5) × 3/12 $200,000 × 0.10 × 3/12 Accruing Bond Interest

32. 32 Interest Expense 5,558.40 Interest Payable5,000.00 Discount on Bonds Payable558.40 $5,558.40 – $5,000.00 Accruing Bond Interest At the end of the fiscal year, December 31, 2010, an adjusting entry is required to record interest for three months (assume the effective-interest amortization). $185,279 × 0.12 × 3/12

33. 33 1.The debtor pays the creditor and is relieved of its obligation for the liability. 2.The debtor is released legally from being the primary obligor under the liability. Under GAAP, a liability is considered extinguished for financial reporting purposes if either of the following occurs: Extinguishment of Liabilities

34. 34  Over the remaining life of the old issue  Over the life of the new bond issue  In the current period Conceptually, gains or losses from refundings could be recognized either: Bonds Retired Prior to Maturity

35. 35 Whether bonds are recalled, retired, or refunded prior to maturity, any gain or loss is reported as a component of income from continuing operations in the current period. Bonds Retired Prior to Maturity

36. 36 1.The right to receive interest on the bonds 2.The right to acquire common stock and to participate in the potential appreciation of the market value of the company’s common stock By acquiring bonds with detachable stock warrants or with a conversion feature, the bondholder has: Bonds with Equity Characteristics

37. 37 Some bonds are issued with rights (warrants) to acquire capital stock. If the warrants are detachable, a portion of the proceeds from selling the bonds must be allocated to the stock warrants. Bonds with Equity Characteristics

38. 38 + Amount Assigned to Bonds = Market Value of Bonds Without Warrants Market Value of Warrants Issuance Price × Bonds Issued with Detachable Stock Warrants Amount Assigned to Warrants = Market Value of Warrants Market Value of Bonds Without Warrants Market Value of Warrants Issuance Price × +

39. 39 Why issue convertible bonds? Convertible Bonds

40. 40 1.Avoid the downward price pressures on its stock that placing a large new issue of common stock on the market would cause 2.Avoid the direct sale of common stock when it believes its stock currently is undervalued in the market 3.Penetrate that segment of the capital market that is unwilling or unable to participate in a direct common stock issue 4.Minimize the costs associated with selling securities Convertible Bonds

41. 41  Book value method. Record the stock at the book value of the convertible bonds and do not record a gain or loss. This method is the most widely used.  Market value method. Record the stock at the market value of the stock or debt, whichever is more reliable, and recognize a gain or loss. Conversion Methods

42. 42 Induced Conversions A company that has issued convertible bonds may desire bondholders to convert the bonds to common stock. To induce conversion, the company may add a “sweetener” to the convertible bond issue.

43. 43 Induced Conversions The debtor recognizes an expense equal to the fair value of the “sweetener” and is measured on the date the offer is accepted by the bondholders.

44. 44 Convertible Bonds that May Be Settled with a Cash Payment Normally occur when the bond has an artificially low interest rate and an attractive conversion feature. When a convertible bond can be settled by paying cash, the company must separately report the debt and the conversion feature.

45. 45 IFRS vs. U.S. GAAP  IFRS contain a general principle that an instrument would be classified as a financial liability when it contains an obligation to transfer resources, regardless of the legal form of the instrument.  U.S. GAAP classifies specific instruments.  Therefore, it is possible that many instruments that are classified as equity under U.S. GAAP may be classified as liabilities under IFRS.

46. 46 IFRS vs. U.S. GAAP  IFRS require a company that issues a compound financial instrument containing both liability and equity components to report each component separately on its balance sheet.  While this is similar to U.S. GAAP with respect to bonds with detachable stock warrants, IFRS require companies with convertible debt value to report the debt instrument and the conversion option (an equity instrument) separately.

47. 47 On January 1 of the current year Johnson Company issues a three-year, non-interest-bearing note with a face value of $8,000 and receives $5,694.24 in exchange. Cash 5,694.24 Discount on Notes Payable2,305.76 Notes Payable8,000.00 Contra account to Notes Payable Notes Payable Issued for Cash

48. 48 Johnson Company records the interest expense on the note for the first year. Interest Expense 683.31 Discount on Notes Payable683.31 Notes Payable Issued for Cash Notes payable$ 8,000.00 Less: Unamortized discount (2,305.76) Carrying value at beginning of year$ 5,694.24 × Effective interest rate 0.12 Interest expense and discount amortization$ 683.31

49. 49 Verna Company borrows $100,000 by issuing a three-year, non-interest-bearing note to a customer. In addition, Verna Company agrees to sell inventory to the customer at a reduced price over a five-year period. The firm’s incremental borrowing rate is 12%. Cash 100,000.00 Discount on Notes Payable28,822.00 Notes Payable100,000.00 Unearned Revenue28,822.00 Notes Payable Exchanged for Cash and Rights and Privileges $100,000 – ($100,000 × 0.711789)

50. 50 $71,178 × 0.12 Interest Expense 8,541.36 Discount on Notes Payable8,541.36 Unearned Revenue 5,764.40 Sales Revenue5,764.40 End of First Year $28,822 ÷ 5 years Interest Expense 9,566.32 Discount on Notes Payable9,566.32 Unearned Revenue 5,764.40 Sales Revenue5,764.40 End of Second Year ($71,178 + $8,541.36) × 0.12 Notes Payable Exchanged for Cash and Rights and Privileges

51. 51 1.No interest is stated 2.The stated rate of interest is clearly unreasonable 3.The face value of the note is materially different from the cash sales price of the property, goods, or services, or the fair value of the note at the date of the transaction GAAP says that the stated rate of interest should be presumed fair. This presumption can be overcome only if: Notes Payable Exchanged for Property, Goods, or Services

52. 52 On January 1, 2010 the Marsden Company purchased used equipment from the Joyce Company, issuing a five-year, $10,000 non- interest-bearing note in exchange. Marsden’s incremental borrowing rate is 12%. Equipment5,674.27 Discount on Notes Payable4,325.73 Equipment10,000.00 Notes Payable Exchanged for Property, Goods, or Services Present value

53. 53 Notes Payable Exchanged for Property, Goods, or Services Interest Expense 680.91 Discount on Notes Payable680.91 Depreciation Expense 567.43 Accumulated Depreciation567.43 December 31, 2010 Interest Expense 762.62 Discount on Notes Payable762.62 Depreciation Expense567.43 Accumulated Depreciation567.43 December 31, 2011 ($10,000 – $4,325.73) × 0.12 $10,000 – ($4,325.73 – $680.91) × 0.12

54. 54 A note receivable is recorded at the fair value of the property, goods, or services or the fair value of the note, whichever is more reliable. Long-Term Notes Receivable

55. 55 On January 1, 2010 the Joyce Company accepted a $10,000, non-interest-bearing, five-year note in exchange for used equipment it sold to the Marsden Company. Joyce uses Marsden’s 12% incremental borrowing rate. Notes Receivable 10,000.00 Accumulated Depreciation3,000.00 Discount on Notes Receivable4,325.73 Equipment8,000.00 Gain on Sale of Equipment674.27 $10,000 – $5,674.27 (present value of equipment) Notes Receivable Exchanged for Property, Goods, or Services

56. 56 Discount on Notes Receivable 680.91 Interest Revenue680.91 December 31, 2010 ($10,000 – $4,325.73) × 0.12 Discount on Notes Receivable 762.62 Interest Revenue762.62 December 31, 2011 $10,000 – ($4,325.73 – $680.91) × 0.12 Notes Receivable Exchanged for Property, Goods, or Services

57. 57 A loan is impaired if it is probable that the creditor will not be able to collect all amounts due according to the contract terms. Impairment of a Loan

58. 58 Snook Company has a $100,000 note receivable from the Ullman Company that it is carrying at face value. The loan agreement called for Ullman to pay 8% interest each December 31 and the principal on December 31, 2015. Ullman paid the December 31, 2010 interest, but informed Snook that it probably would miss the next two years’ interest payments because of financial difficulties. In addition, the principal payment would be one year late. Impairment of a Loan

59. 59 Snook Company computes the present value of the impaired loan. Present value of principal = $100,000 × present value of a single sum for 6 years at 8% =$100,000 × 0.630170 =$63,017.00 Present value of interest = $8,000 × present value of an annuity for 4 years at 8% deferred 2 years =$8,000 × 3.312127 × 0.857339 =$22,716.93 Value of the impaired loan = $85,733.93 ($63,017.00 + $22,716.93) Impairment of a Loan

60. 60 Bad Debt Expense 14,266.07 Allowance for Doubtful Notes14,266.07 December 31, 2010 (Snook Company) Allowance for Doubtful Notes 6,858.71 Interest Revenue6,858.71 December 31, 2011 (Snook Company) 8% × $85,733.93 Notes Receivable Exchanged for Property, Goods, or Services $100,000 – $85,733.93

61. 61 IFRS vs. U.S. GAAP  When a loan is impaired, IFRS, similar to GAAP, require a company to compute the loss as the difference between the carrying value of the receivable and the present value f the future cash flows.  IFRS allow the company to record the loss by reducing the receivable directly or through the use of an allowance account. Also, if in a later period the impairment decreases, IFRS allow the company to reverse the impairment loss.

62. 62 Guarantees Sometimes a company may guarantee another company’s debt. For example, suppose the Probst Company sells a product to the Metcalf Company for $10 million. Since Metcalf does not have sufficient cash, it decides to take out a bank loan to finance the purchase. However, its financial status is such that the bank will not provide an unsecured loan. So, the Probst Company agrees to guarantee Metcalf’s loan from the bank so that it can make the sale. GAAP requires the Probst Company to determine the fair value of the guarantee and recognize it as a liability.

63. 63 1.Reduction of the stated interest rate for the remaining original life of the debt 2.Extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk 3.Reduction of the face amount or maturity amount of the debt 4.Reduction of accrued interest Modification of Terms Click button to skip Appendix material Appendix 1: Troubled Debt Restructuring

64. 64 The debtor grants an equity interest to the creditor to satisfy a debt unless the equity interest is granted under existing terms for converting the debt into an interest. Issuance or other granting of an equity interest Appendix 1: Troubled Debt Restructuring The debtor may transfer assets to the creditor to satisfy a debt. Transfer of receivables, real estate, or other assets

65. 65 Modification of Terms When a restructuring involves only a modification of terms, the carrying value of the liability is compared to the undiscounted future cash payments specified by the new terms. Then, two different situations may arise: ContinuedContinued Appendix 1: Accounting by the Debtor

66. 66 1.If the undiscounted total future cash payments are greater than (or equal to) the carrying value of the liability, the debtor does not recognize a gain, the carrying value is not reduced, and interest expense is recognized in future periods using an imputed interest rate. ContinuedContinued Appendix 1: Accounting by the Debtor

67. 67 2.If the future cash payments are less than the carrying value of the liability, the debtor recognizes a gain, the carrying value of the liability is reduced, and interest expense is not recognized in future periods. Appendix 1: Accounting by the Debtor

68. 68 No Gain Recognized by the Debtor Appendix 1: Accounting by the Debtor  When there is a modification of terms and the total cash to be repaid over the remaining life of the loan is greater than (or equal to) the carrying value of the liability, the debtor makes no adjustment to the carrying value.  The debtor recognizes annual interest expense using the effective interest method.  The imputed interest rate used is the rate that equates to total amount of cash to be paid with the current carrying value of the debt.

69. 69 Gain Recognized by the Debtor Appendix 1: Accounting by the Debtor  An adjustment to the carrying value of the liability is required if the total cash to be repaid over the remaining life of the loan is less than the carrying value. In this case, the debtor recognizes a gain equal to the excess of the carrying value (face value plus accrued interest) over the sum of the future payments.

70. 70 Equity or Asset Exchange When a debtor satisfies a liability by exchanging an equity interest or an asset of lesser value, it records the transfer on the basis of the fair value of the equity interest or asset transferred and recognizes a gain on the debt restructuring. Appendix 1: Accounting by the Debtor

71. 71 Disclosure of Restructuring Agreements Appendix 1: Accounting by the Debtor The following disclosures are required for debtors who have entered into restructuring agreements:  A description of the principal changes in terms and/or major features of the settlement for each restructuring agreement  The aggregate gain on debt restructures and the related income tax effect  The per share amount of the aggregate gain on restructuring and the related income tax effect  The aggregate gain or loss recognized during the period on transfers of assets  Information on contingent payments

72. 72 C hapter 14 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.