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Long Term Liabilities and Receivables C hapter 14 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by.

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1 Long Term Liabilities and Receivables C hapter 14 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 2 1.A bond is a debt security that is issued to obtain large amounts of cash on a long term basis. 2.A bond indenture is the formal agreement which specifies the terms of the bonds. Bonds

3 3 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

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

5 5 1.The principal, face, par or maturity value is the amount that the corporation will pay the bond holder at the maturity of a term bond. 2.The stated rate, coupon rate, nominal rate, or contractual rate is the interest rate printed on the bond. 3.The market rate, effective rate, or yield is the interest rate at which the bonds are actually sold. Bond Terminology

6 6 Company J sells bonds with a face value of $400,000 on the authorization date at 102. Cash ($400,000 x 1.02)408,000 Bonds Payable400,000 Premium on Bonds Payable8,000 Company M sells bonds with a face value of $400,000 on the authorization date at 97. Cash ($400,000 x.97)388,000 Discount on Bonds Payable12,000 Bonds Payable400,000 Recording the Issuance of Bonds

7 7 On March 1, 2007, Grimes Corporation issues $800,000 of 10-year bonds dated January 1, 2007, at par. The bonds have a contract (stated) interest rate of 12% and pay interest semiannually. Cash 816,000 Bonds Payable800,000 Interest Expense16,000 $800,000 x 0.12 x 2/12 ContinuedContinued Bonds Issued Between Interest Paying Dates

8 8 On July 1, 2007, Grimes Corporation records the semiannual interest payment. Interest Expense48,000 Cash48,000 $800,000 x 0.12 x 6/12 Interest Expense 48,000 16,000 Bonds Issued Between Interest Paying Dates The balance of $32,000 represents the interest cost since the bonds were issued. 32,000

9 9 March1Cash816,000 Interest Payable ($800,000 X 0.12 X 6/12)16,000 Bonds Payable800,000 July1Interest Expense ($800,000 X 0.12 X 4/12)$ 32,000 Interest Payable16,000 Cash$ 48,000 Bonds Issued Between Interest Paying Dates Alternative Method

10 10Straight-LineMethodStraight-LineMethod

11 11 Jet Company sells bonds for $92, on January 1, The bonds have a face value of $100,000 and a 12% stated annual interest rate and a 14% effective rate. Interest is paid semiannually and the bonds mature on December 31, Cash92, Discount on Bonds Payable7, Bonds Payable100, ContinuedContinued Issuing Bonds at a Discount

12 12 Jet Company records the first interest payment on June 30, Interest Expense6, Discount on Bonds Payable Cash6, $6,000 + $ $7, ÷ 10 $100,000 x 0.12 x 1/2 Straight-Line Method Bonds Issued at a Discount

13 13 Jet Company sold the 5-year bonds on January 1, 2007, for $107, Interest is paid semiannually. Cash107, Bonds Payable100, Premium on Bonds Payable7, ContinuedContinued Straight-Line Method Bonds Issued at a Premium

14 14 The first interest payment is made on June 30. Interest Expense5, Premium on Bonds Payable Cash ($100,0000 x 0.12 x 1/2)6, ContinuedContinued Straight-Line Method Bonds Issued at a Premium $7, ÷ 10

15 15 Jet Company desires to sell $100,000 of 5-year bonds paying semiannual interest with a stated rate of 12%. The current effective interest rate is 14%. Present value of principal ($100,000 x )$ 50, Present value of interest ($6,000 x ) 42, $ 92, Less face value(100,000.00) Discount$ 7, Determining the Selling Price

16 16 Jet Company desires to sell $100,000 of 5-year bonds paying semiannual interest with a stated rate of 12%. The bonds are sold to yield 14% interest. Present value of principal ($100,000 x )$ 61, Present value of interest ($6,000 x ) 46, $107, Less face value(100,000.00) Premium$ 7, Determining the Selling Price

17 17 Effective Interest Method

18 18 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

19 19 Jet Company sells bonds for $92, on January 1, The bonds have a face value of $100,000 and a 12% stated annual interest rate and a 14% effective rate. Interest is paid semiannually and the bonds mature on December 31, Cash92, Discount on Bonds Payable7, Bonds Payable100, ContinuedContinued Issuing Bonds at a Discount Effective Interest

20 20 $100,000 x 0.12 x 1/2 Jet Company records the first interest payment on June 30, Interest Expense6, Discount on Bonds Payable Cash6, $92, x 0.14 x 1/2 $6, $6, Issuing Bonds at a Discount Effective Interest

21 21 $100,000 x 0.12 x 1/2 Jet Company records the second interest payment on December 31, Interest Expense6, Discount on Bonds Payable Cash6, ($92, $508.35) x 0.14 x 1/2 $6, , Issuing Bonds at a Discount Effective Interest

22 22 Jet Company sold bonds on January 1, 2007, for $107, Interest is paid semiannually. Cash107, Bonds Payable100, Premium on Bonds Payable7, ContinuedContinued Effective Interest Issuing Bonds at a Premium

23 23 The first interest payment is made on June 30. Premium on Bonds Payable Interest Expense5, Cash 6, ContinuedContinued Effective Interest $107, x 0.10 x 1/2 $100,000 x 0.12 x 1/2 $100,000 x 0.12 x 1/2 Issuing Bonds at a Premium $6, – $5, $5,386.09

24 24 $100,000 x 0.12 x 1/2 Jet Company records the second interest payment on December 31, Interest Expense5, Premium on Bonds Payable Cash6, ($107, $613.91) x 0.10 x 1/2 $6, $5, Issuing Bonds at a Premium Effective Interest

25 25 On January 1, 2007, Bergen Company issues 10-year bonds with a face value of $500,000 at 107. 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, x $500,000 Bond Issue Costs

26 26 Each year for the ten years Deferred Bond Issue Costs is amortized on a straight-line basis by charging Bond Interest Expense for $800. Bond Issue Costs However, the FASB is planning to change GAAP, so that all debt issue costs are expensed as incurred.

27 27 McAdams Company issues $200,000 of 10%, 5-year bonds on October 1, 2007, for $185, Interest on these bonds is payable each October 1 and April 1. Cash 185, Discount on Bonds Payable14, Bonds Payable200, ContinuedContinued Accruing Bond Interest

28 28 At the end of the fiscal year, December 31, 2007, an adjusting entry is required to record interest for three months (assume straight-line amortization). Interest Expense (plug)5, Discount on Bonds Payable Interest Payable5, ($14, ÷ 5) x 3/12 $200,000 x 0.10 x 3/12 Accruing Bond Interest

29 29 At the end of the fiscal year, December 31, 2007, an adjusting entry is required to record interest for 3 months (assume the effective-interest amortization). Interest Expense 5, Interest Payable5, Discount on Bonds Payable (plug) $185,279 x 0.12 x 3/12 $5, $5, Accruing Bond Interest

30 30 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, either judicially or by the creditor. Under FASB Statement No. 140, a liability is considered extinguished for financial reporting purposes if either of the following occurs: Extinguishment of Debt

31 31  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

32 32 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

33 33 Channing Corporation originally issued $100,000 of 12% bonds at 97 on January 1, The bonds have a 10-year life, pay interest on January 1 and July 1, and are callable at 105 plus accrued interest. The company amortizes the discount by the straight-line method. ContinuedContinued On June 30, 2007, the company recalls the bonds. Bonds Retired Prior to Maturity

34 34 Interest Expense6,150 Discount on Bonds Payable150 Interest Payable6,000 First, Channing records the current interest expense and liability, including the amortization of the discount that expired since the last interest payment. ($3,000 ÷ 10) x 1/2 $100,000 x 0.12 x 1/2 Bonds Retired Prior to Maturity

35 35 Bonds Payable100,000 Interest Payable6,000 Loss on Bond Redemption6,350 Discount on Bonds Payable1,350 Cash111,000 Channing then records the reacquisition of the bonds at 105 plus accrued interest of $6,000. Original discount$ 3,000 Less: Amortization Less: Amortization for 5 1/2 years(1,650) for 5 1/2 years(1,650) Unamortized discount$1,350 Bonds Retired Prior to Maturity

36 36 1.the right to receive interest on the bonds, and… 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 warrants.  Proportional method  Incremental method 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 warrants.  Proportional method  Incremental method Bonds with Equity Characteristics

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

39 39 Paul Company sold $800,000 of 12% bonds at 101 ($808,000). Each bond carried 10 warrants, and each warrant allows the holder to acquire one share of $5 par common stock for $25 per share. The bonds are quoted at 99 ex rights and the warrants at $3 each. Bonds Issued with Detachable Stock Warrants

40 40 Amount Assigned to Bonds = Market Value of Bonds Without Warrants + Market Value of Warrants Issuance Price x Amount Assigned to Bonds = $990 per bond x 800 bonds ($990 x 800) + ($3 x 800 x 10) $808,000 x Amount Assigned to Bonds = $784, Bonds Issued with Detachable Stock Warrants

41 41 Amount Assigned to Warrants = Market Value of Warrants Market Value of Bonds Without Warrants + Market Value of Warrants Issuance Price x Amount Assigned to Warrants = $3 x 10 warrants x 800 bonds ($990 x 800) + ($3 x 800 x 10) $808,000 x Amount Assigned to Warrants = $23, Bonds Issued with Detachable Warrants

42 42 Cash808, Discount on Bonds Payable15, Bonds Payable800, Common Stock Warrants23, From last slide Bonds Issued with Detachable Stock Warrants $800, $784,235.29

43 43 Cash12, Common Stock Warrants1, Common Stock2, Additional Paid-in Capital on Common Stock11, Later, 500 warrants are exercised at $25 each. ($23, ÷ 8,000) x 500 Common Stock Warrants22, Additional Paid-in Capital from Expired Warrants 22, The remaining warrants expire. $23, $1, Bonds Issued with Detachable Warrants

44 44 Why issue convertible bonds? Convertible Bonds

45 45 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

46 46  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

47 47 Conversion Methods Shannon Corporation has outstanding convertible bonds with a face value of $10,000 and a book value of $10,500. Each bond is convertible into 40 shares of $20 par common stock. The market price is $26.50 per share when the shares are converted.

48 48 Book Value Method- The market price is not considered. Bonds Payable10,000 Premium on Bonds Payable 500 Common Stock 8,000 Additional-Paid-in Capital-plug 2,500 Book Value Method- The market price is not considered. Bonds Payable10,000 Premium on Bonds Payable 500 Common Stock 8,000 Additional-Paid-in Capital-plug 2,500 Market Value Method-Equity accounts equal market price. Bonds Payable10,000 Premium on Bonds Payable 500 Loss on Conversion 100 Common Stock 8,000 Additional-Paid-in Capital 2,600 Market Value Method-Equity accounts equal market price. Bonds Payable10,000 Premium on Bonds Payable 500 Loss on Conversion 100 Common Stock 8,000 Additional-Paid-in Capital 2,600 Conversion Methods

49 49 Induced Conversions A company that has 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. 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.

50 50 Induced Conversions Assume that Harmon Company had $10,000 of outstanding convertible bonds, which had been issued at par. The original terms of issuance allowed each bond to be converted into 40 shares of no-par common stock. To induce conversion, the terms were changed to offer 50 shares per bond. All shares were converted when the market price was $30 per share. Bonds Payable10,000 Bond Conversion Expense3,000 Common Stock, no par13,000

51 51 On January 1 of the current year, Johnson Company issues a 3-year, non-interest-bearing note with a face value of $8,000 and receives $5, in exchange. Cash 5, Discount on Notes Payable2, Notes Payable8, Contra account to Notes Payable Notes Payable Issued for Cash

52 52 Johnson Company records the interest expense on the note for the first year. Interest Expense Discount on Notes Payable Notes payable$8, Less: Unamortized discount(2,305.76) Carrying value at beginning of year$5, x Effective interest rate 0.12 Entry amount$ Notes Payable Issued for Cash

53 53 1.No interest is stated, or 2.The stated rate of interest is clearly unreasonable, or 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. APB Opinion No. 21 states that the stipulated rate of interest should be presumed fair. This presumption can be overcome only if-- Notes Payable Exchanged for Property, Goods or Services

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, 2007, Marsden Company purchased used equipment from Joyce Company, issuing a 5 year, $10,000 non-interest-bearing note in exchange. Marsden’s incremental interest rate is 12%. Equipment5, Discount on Notes Payable4, Equipment10, Long-Term Notes Payable Present value

56 56 Interest Expense Discount on Notes Payable December 31, 2007 ($10,000 – $4,325.73) x 0.12 Interest Expense Discount on Notes Payable December 31, 2008 $10,000 – ($4, – $680.91) x 0.12 Long-Term Notes Payable Depreciation Expense Accumulated Depreciation

57 57 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

58 58 On January 1, 2007, Joyce Company accepted a $10,000 non-interest-bearing, 5-year note in exchange for used equipment it sold to Marsden Company (12%). Notes Receivable 10, Accumulated Depreciation3, Discount on Notes Receivable4, Equipment8, Gain on Sale of Equipment $10,000 – $5, (present value of equipment) Long-Term Notes Receivable

59 59 Discount on Notes Receivable Interest Revenue December 31, 2007 ($10,000 – $4,325.73) x 0.12 Discount on Notes Receivable Interest Revenue December 31, 2008 $10,000 – ($4, – $680.91) x 0.12 Long-Term Notes Receivable

60 60 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

61 61 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, Ullman paid the December 31, 2007, interest, but informed Snook that it probably would miss the next two year’s interest payments because of financial difficulties. In addition, the principal payment would be one year late. Impairment of a Loan

62 62 Snook Company computes the present value of the impaired loan. Present value of the principal = $100,000 x present value of a single sum for 6 years at 8% =$100,000 x =$63, Present value of the interest = $8,000 x present value of an annuity for 4 years at 8% deferred 2 years =$8,000 x x =$22, Value of the impaired loan is $85, ($63, $22,716.93) Impairment of a Loan

63 63 Bad Debt Expense 14, Allowance for Doubtful Accts.14, December 31, 2007, (Snook Company) Allowance for Doubtful Accounts 6, Interest Revenue6, December 31, 2008, (Snook Company) $100,000 – $85, % x $85, Impairment of a Loan

64 64 C hapter 14 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.


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