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Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD,

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Presentation on theme: "Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD,"— Presentation transcript:

1 Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

2 C H A P T E R 15 Long-Term Financial Liabilities

3 1. Describe the formal procedures associated with issuing long-term debt. 2. Identify various types of long-term debt. 3. Explain the initial measurement of bonds/notes at date of issuance. 4. Apply the methods of bond discount and premium amortization. Learning Objectives

4 5.Value bonds and consideration in special situations. 6. Describe the accounting procedures for the extinguishment of debt. 7. Explain the issues surrounding off-balance-sheet financing arrangements. 8. Indicate how long-term debt is presented and analysed. Learning Objectives

5 9.Account for impairments on notes and loans receivable. (Appendix 15A) 10.Distinguish between and account for debt restructurings resulting in extinguishment versus debt continuation. (Appendix 15A)

6 Long-Term Financial Liabilities Nature of Long-term Debt Bonds Notes payable Types of bonds/notes Bond ratings Recognition and Presentation Off-balance- sheet financing Presentation Long-term debt Note disclosures Measurement and Valuation Bonds/Notes issued at par Discounts and premiums Deep discount/zero interest bonds/notes Special situations Issuance costs Extinguishment/ Derecognition Repayment prior to maturity date Exchange of debt instruments Defeasance Perspectives Appendix 15A- Troubled Debt Impairment of Loans/Notes receivable Troubled debt restructuring

7 Issuing Long-Term Debt Obligations not payable within one year, or one business operating cycle—whichever is longerObligations not payable within one year, or one business operating cycle—whichever is longer Examples include:Examples include: –Bonds payable –Long-term notes –Mortgages –Pension liabilities –Lease liabilities Often with restrictive covenants (terms) attachedOften with restrictive covenants (terms) attached

8 Bonds Most common type of long-term debtMost common type of long-term debt A bond indenture is a promise (by the lender to the borrower) to pay:A bond indenture is a promise (by the lender to the borrower) to pay: a sum of money at the designated date, anda sum of money at the designated date, and periodic interest at a stipulated rate on the face valueperiodic interest at a stipulated rate on the face value A bond issue may be sold:A bond issue may be sold: either through an investment banker, oreither through an investment banker, or by private placementby private placement

9 Notes Payable Similar in nature to bondsSimilar in nature to bonds –Require repayment of principal at a future date –Require periodic interest payments Difference is notes do not normally trade on public marketsDifference is notes do not normally trade on public markets Accounting for bonds and notes is the same in many respectsAccounting for bonds and notes is the same in many respects

10 Types of Long-Term Debt Bearer bonds: are freely transferable by current ownerBearer bonds: are freely transferable by current owner Secured and unsecured debt: secured by collateral (real estate, stocks)Secured and unsecured debt: secured by collateral (real estate, stocks) Serial bonds: mature in instalmentsSerial bonds: mature in instalments Callable bonds: give issuer right to call and retire debt prior to maturityCallable bonds: give issuer right to call and retire debt prior to maturity Income and Revenue bonds: interest payments tied to some form of performanceIncome and Revenue bonds: interest payments tied to some form of performance Deep-discount bonds: little or no interest payments; sold at substantial discountDeep-discount bonds: little or no interest payments; sold at substantial discount Convertible bonds: can be converted into other corporate securities for a specified time after issueConvertible bonds: can be converted into other corporate securities for a specified time after issue

11 Price of a bond issue is determined by finding the present value (PV) of future cash flows: Price of a bond issue is determined by finding the present value (PV) of future cash flows: the PV of the interest payment annuity (at the stated or coupon rate of interest), plus the PV of the interest payment annuity (at the stated or coupon rate of interest), plus the PV of the redemption (face, par) value, the PV of the redemption (face, par) value, both discounted at the market (yield) rate of interest in effect at issue date both discounted at the market (yield) rate of interest in effect at issue date When market rate  stated rate  bond sells at discount When market rate  stated rate  bond sells at discount When market rate  stated rate  bond sells at premium When market rate  stated rate  bond sells at premium Bond Valuation: Determining Bond Prices

12 Given:  Face value of bond issue: $100,000  Term of issue: 5 years  Stated interest rate: 9% per year, payable end of the year  Market rate of interest: 11% Determine the issue price of the bonds. Determine the issue price of the bonds. Bond Valuation: Bond Price Calculation

13 Year 1 Year 2 Year 3 Year 4 Year 5 Bond Valuation: Bond Price Calculation $9,000$9,000$9,000$9,000$9,000 Interestannuity $100,000 Face Value Discount the future cash flows using the market (yield) rate of interest

14 Year 1 Year 2 Year 3 Year 4 Year 5 $9,000$9,000$9,000$9,000$9,000 Discount at market rate, 11% $9,000 x $33,263 $100,000 Discount at market rate, 11% $100,000 x $ 59,345 plus =$92,608 is the issue price Bond Valuation: Bond Price Calculation

15 Entries for the Issuance of Bonds Sold at Par Cash1,000 Bonds Payable1,000 Sold at a Premium Cash1,100 Premium on Bonds 100 Bonds Payable1000 Sold at a Discount Cash 900 Discount on Bonds 100 Bonds Payable1000

16 Amortizing the Bond Premium/Discount A premium effectively decreases the annual interest expense for the corporationA premium effectively decreases the annual interest expense for the corporation The discount effectively increases the annual interest expense for the issuing corporationThe discount effectively increases the annual interest expense for the issuing corporation

17 Amortizing the Bond Premium/Discount Two methods available for amortizationTwo methods available for amortization –Straight line allocates the same amount of discount (or premium) to each interest periodallocates the same amount of discount (or premium) to each interest period –Effective interest allocates the discount or premium in increasing amounts over the bond termallocates the discount or premium in increasing amounts over the bond term

18 Amortizing the Bond Premium/Discount The total discount or premium amortized is the same under both methodsThe total discount or premium amortized is the same under both methods The straight-line method of amortizing is acceptable under GAAP only if the results are not materially different from those produced by using the effective interest methodThe straight-line method of amortizing is acceptable under GAAP only if the results are not materially different from those produced by using the effective interest method

19 Straight-Line Method—Discount Given: Face Value = $800,000 Discount = $24,000 Coupon Rate = 10% Bond Maturity = 10 years The annual discount amortization = $24,000  10 years = $2,400 The entry to record the annual discount amortization would be: Interest Expense2,400 Discount on Bonds2,400

20 Straight-Line Method—Premium Given: Face Value = $800,000 Premium = $24,000 Coupon Rate = 10% Bond Maturity = 10 years The annual premium amortization = $24,000  10 years = $2,400 The entry to record the annual premium amortization would be Premium on Bonds2,400 Interest Expense2,400

21 Effective Interest Method Considers the change in interest costs as the life of the bonds increasesConsiders the change in interest costs as the life of the bonds increases Uses the market rate at the date of sale to calculate the amortization amount over the life of the bondUses the market rate at the date of sale to calculate the amortization amount over the life of the bond

22 Effective Interest Method Calculation

23 Effective Interest Method Cash92,278 Discount on Bonds Payable 7,722 Bonds Payable100,000 The journal entry to record the bond issuance is:

24 Effective Interest Method Bond Interest Expense4,614 Discount on Bonds Payable 614 Cash4,000 The journal entry for first semi-annual payment is:

25 Effective Interest Method Calculation

26 Effective Interest Method Cash 108,530 Premium on Bonds Payable 8,530 Bonds Payable 100,000 The journal entry to record the bond issuance is:

27 Effective Interest Method Bond Interest Expense3,256 Premium on Bonds Payable 744 Cash4,000 The journal entry for first semi-annual payment is:

28 Balance Sheet Presentation Discount on bonds payable is a contra account: Bonds Payable (face value): $ XXX Less: Unamortized Discount : ($ XX) Bonds Payable (carrying value): $ XXX Premium on bonds payable is an adjunct account: Bonds Payable (face value) : $ XXX Add: Unamortized Premium : $ XX Bonds Payable (carrying value): $ XXX

29 Interest, for the period between the issue date and the last interest date, is collected with the issue price of the bondsInterest, 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)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 periodPremium or discount is also amortized from the date of sale of bonds to the end of the interest period Bonds Issued Between Interest Dates

30 Deep Discount/Zero-Interest- Bearing Bonds/Notes If issued for cash PV = cash received by issuerIf issued for cash PV = cash received by issuer Interest rate is the rate that causes the PV (of future cash flows) to equal cash receivedInterest rate is the rate that causes the PV (of future cash flows) to equal cash received Difference between face amount and PV is the discountDifference between face amount and PV is the discount –Amortized over life of the note

31 Deep Discount/Zero-Interest- Bearing Bonds/Notes Example: Jeremiah Company 10,000 3-year zero-interest-bearing note issued10,000 3-year zero-interest-bearing note issued Cash received at issuance: $ Cash received at issuance: $ Discount equal to:$10,000 Less: Cash 7,722 $ 2,278Discount equal to:$10,000 Less: Cash 7,722 $ 2,278 Implied interest rate therefore: 9%Implied interest rate therefore: 9%

32 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 rightsSometimes, 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 buyerThen, the borrower is also the seller and the lender is also the buyer The borrower must record both:The borrower must record both: a discount on the note, anda discount on the note, and unearned revenueunearned revenue Example

33 Note Issued for Cash and Other Rights Given: Issuer gives a 5 year, $100,000 note payable to recipient on January 1 stIssuer gives a 5 year, $100,000 note payable to recipient on January 1 st The note is zero-interest bearingThe note is zero-interest bearing The market rate is 10%The market rate is 10% Recipient company has special rights to buy $500,000 of merchandise from issuer company at below market pricesRecipient company has special rights to buy $500,000 of merchandise from issuer company at below market prices Journalize in issuer’s booksJournalize in issuer’s books

34 Note Issued for Cash and Other Rights Books of the Issuer: Cash100,000 Cash100,000 Discount on Note Payable 37,908 Discount on Note Payable 37,908 Note Payable 100,000 Note Payable 100,000 Unearned Revenue 37,908 Unearned Revenue 37,908 PV of 100,000 at 10%, (n=5) = 62,902 Discount: (100,000 – 62,902) = 37,908 The discount is amortized over the term of note The (unearned) revenue is recognized as sales are made

35 Note Issued for Cash and Other Rights Assume that the recipient purchased $50,000 worth of merchandise from the issuer. The journal entry to record that revenue: Cash (or A/R: Recipient)46,209 Unearned Revenue 3,791 Sales Revenue50,000 Sales Revenue50,000 (Revenue recognized = $ 37,908 x ( $50,000/$500,000) = $3,791 = $3,791

36 Notes Issued for Property, Goods, and Services Notes issued and payment is asset other than cashNotes issued and payment is asset other than cash PV of debt at fair value of the property, goods or services if:PV of debt at fair value of the property, goods or services if: 1.No stated interest rate 2.Stated interest rate is unreasonable 3.Material difference exists between the stated value of note and market value of the asset being exchanged Any discount or premium amortized over life of the noteAny discount or premium amortized over life of the note

37 Bond Issue Costs Those costs incurred to physically issue the bondsThose costs incurred to physically issue the bonds –e.g., costs paid to the broker, legal costs Not part of any premium or discountNot part of any premium or discount Debited to a deferred chargeDebited to a deferred charge Amortized over the life of the bond, using straight line methodAmortized over the life of the bond, using straight line method

38 Extinguishment of Debt When debt is paid out prior to maturityWhen debt is paid out prior to maturity –Reacquisition, requires gain or loss to be recorded May be for full amount of debt, or a portionMay be for full amount of debt, or a portion At the time of reacquisition all outstanding premiums, discounts, and issue costs are amortized to the date of reacquisitionAt the time of reacquisition all outstanding premiums, discounts, and issue costs are amortized to the date of reacquisition Any gain or loss from the reacquisition is reported with other capital gains/losses (does not qualify as an extraordinary item)Any gain or loss from the reacquisition is reported with other capital gains/losses (does not qualify as an extraordinary item)

39 Extinguishment of Debt Generally, when bonds are reacquired they are cancelledGenerally, when bonds are reacquired they are cancelled If they are not cancelled, they are considered treasury bondsIf they are not cancelled, they are considered treasury bonds –May be resold or subsequently cancelled Treasury bonds are reported as a deduction from Bonds Payable on the balance sheetTreasury bonds are reported as a deduction from Bonds Payable on the balance sheet Refunding of bonds: when a bond issue is called in and replaced with a new issue (at a lower rate of interest)Refunding of bonds: when a bond issue is called in and replaced with a new issue (at a lower rate of interest)

40 Extinguishment of Debt: Example Given: Existing debt:$800,000Existing debt:$800,000 Called and canceled at:$808,000Called and canceled at:$808,000 Unamortized discount:$ 14,400Unamortized discount:$ 14,400 Unamortized bond issue costs:$ 9,600Unamortized 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.

41 Bonds Payable800,000 Loss on Redemption of Bonds 32,000 Discount on Bonds 14,400 Discount on Bonds 14,400 Unamortized Bond Issue Costs 9,600 Unamortized Bond Issue Costs 9,600 Cash 808,000 Cash 808,000 Extinguishment of Debt: Example

42 Defeasance Sufficient funds set aside (i.e. trust) to pay off principal and interest on the debtSufficient funds set aside (i.e. trust) to pay off principal and interest on the debt “Legal defeasance” occurs when the debt holder no longer has claim on the assets of the original issuer“Legal defeasance” occurs when the debt holder no longer has claim on the assets of the original issuer –Trust held responsible for repayment “In-substance defeasance” occurs when the debt holder is not aware of the trust arrangement“In-substance defeasance” occurs when the debt holder is not aware of the trust arrangement –CICA Handbook, Section 3855 (proposed) will deal with whether or not this is deemed an extinguishment of debt

43 Off-balance-sheet financing represents borrowing arrangements that are not recordedOff-balance-sheet financing represents borrowing arrangements that are not recorded The amount of debt reported in the balance sheet does not include such financing arrangementsThe 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)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 entityIn 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 companiesThe debt appears on the books of the new entity, and not on those of the parent companies Off-Balance-Sheet Financing

44 Different forms of off-balance-sheet financingDifferent forms of off-balance-sheet financing 1.Non-consolidated subsidiaries 2.Special Purpose Entities (SPE) or Variable Interest Entities (VIE) 3.Operating Leases

45 Presentation of Long-Term Debt Current versus long-termCurrent versus long-term –Debt to be refinanced treated as long-term Debt versus equityDebt versus equity –Dependent on nature of the instrument Classification of Discount and PremiumClassification of Discount and Premium –Discount – contra account –Premium – adjunct account –Both reported within liability

46 Note Disclosure Include:Include: –Nature of the liability –Maturity date –Interest rate –Call provision –Conversion privileges –Any restrictions imposed –Assets designated or pledged as security

47 Long-Term Debt Analysis Debt to Total Assets:Total debt Total assets Total assets Level or percentage of assets that is financed through debtLevel or percentage of assets that is financed through debt Times Interest Earned: Income before income taxes and interest Interest Expense Measures ability to meet interest paymentsMeasures ability to meet interest payments

48 Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. COPYRIGHT


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