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

2. 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

3. 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

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

5. 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/ $108,530
7/1/98 $4, $3, $ ,786
1/1/ , , ,020
7/1/ , , ,231
Interest expense = carrying value x yield rate
Premium amortized = cash paid - interest expense
Chang, Otto

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

7. 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

8. 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 ,000
Unamortized Bond Issue Cost ,000
Premium on Bonds Payable ,000
Bonds Payable ,000
Chang, Otto

9. 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 ,000
Discount on Bonds Payable ,400
Unamortized Bonds Issue Cost ,600
Cash ,000
Chang, Otto

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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 $ x = $225,396
Less: carrying value on 12/31/ ,657
Bad debt expense recognized ($150,261)

16. 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 , N/P ,000
B/D allowance 4, Loss on land 5,000
N/P , Land ,000
Gain on debt 4,000

17. 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.

18. 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.

19. 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

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

21. 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 ,593,428*
Allowance for B/D ,593,428
* $10,500,000 - $7,906,572
To record Interest revenue on 12/31/99
Cash ,000
Allowance for B/D ,789
Interest Revenue ,789*
* 7,906,572 x 12%
Chang, Otto

22. 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

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

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