Prepared by Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

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

Learning Objectives 1. Describe the formal procedures associated with issuing long-term debt. 2. Identify various types of bond issues. 3. Describe the accounting valuation for bonds at date of issuance. 4. Apply the methods of bond discount and premium amortization.

Learning Objectives 5. Describe the accounting procedures for the extinguishment of debt. 6. Explain the accounting procedures for long-term notes payable. 7. Explain the reporting of off-balance-sheet financing arrangements. 8. Indicate how long-term debt is presented and analysed.

Long-term Financial Liabilities Bonds Payable Issuing Bonds Types and ratings Valuation Effective interest method Cost of issuing Treasury bonds Extinguishment Reporting and Analysis of Long- Term Debt Off-balance-sheet financing Presentation and analysis Long-Term Notes Payable Notes issued at face value Notes not issued at face value Special situations Mortgage notes payable

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

Select Types of Bonds Secured and unsecured bonds : bonds secured by collateral (real estate, stocks) Serial bonds : mature in instalments Callable bonds : give issuer right to call and retire debt prior to maturity Convertible bonds: can be converted into other corporate securities for a specified time after issue Bearer bonds: are freely transferable by current owner

The price of a bond issue is determined by finding the present value of the future cash flows: the present value of the interest payment annuity (at the stated or coupon rate of interest), plus the present value of the redemption (face, par) value, 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 premium Bond Valuation: Determining Bond Prices

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. Bond Valuation: Bond Price Calculation

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 Interest annuity $100,000 Face Value Discount the future cash flows using the market (yield) rate of interest

Year 1 Year 2 Year 3 Year 4 Year 5 $9,000$9,000$9,000$9,000$9,000 market rate Discount at market rate, 11% $9,000 * $ 33,262 $100,000 market rate Discount at market rate, 11% $100,000 * $ 59,345 plus =$92,607 is the issue price Bond Valuation: Bond Price Calculation

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

Amortizing the Bond Premium/Discount A premium effectively decreases the annual interest expense for the corporation The discount effectively increases the annual interest expense for the issuing corporation Two methods available for amortization Straight line allocates the same amount of discount (or premium) to each interest period Effective interest allocates the discount or premium in increasing amounts over the bond term

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

Straight Line Method Given: Face Value = $1,000 Discount = $100 Coupon Rate = 3% Bond Maturity = 5 years The annual discount amortization =$100  5 years = $20 The annual interest payment = $1,000 * 3% = $30 The entry to record the cash payment and discount amortization for each period would be Interest Expense50.00 Cash30.00 Discount on Bonds20.00

Effective Interest Method Considers 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 bond

Effective Interest Method Calculation

Effective Interest Method Interest Expense31.02 Premium on Bonds 8.98 Cash40.00 The journal entry for Year 3 is:

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

Bond Issue Costs Those costs incurred to physically issue the bonds e.g., costs paid to the broker, legal costs Have nothing to do with the premium or discount Debited to a deferred charge Amortized over the life of the bond, using straight line method

Bonds may be issued between interest dates Interest, 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) Premium or discount is also amortized from the date of sale of bonds to the end of the interest period Bonds Issued Between Interest Dates

Bonds Issued at a Premium between Interest Dates: Straight Line Amortization Given: (Fiscal year is calendar year) è Face value of bonds issued:$ 100,000 è Issue Price: (issue at )$ 108,530 è Market Rate:6% è Stated Rate:8% è Date of issue:March 1, 2000 è Interest dates: July 1 and Jan 1 è Term of issue:5 years Give the journal entries for issue and interest payment.

March 1, 2000 (Issue): Cash109,863 Bonds Payable100,000 Premium on Bonds Payable 8,530 Bond Interest Expense 1,333 (Bond interest expense = 100,000 *.08 * 2/12 months) (Cash = 100, , ,333) Bonds Issued at a Premium between Interest Dates: Straight Line Amortization

July 1, 2000 (Interest Payment): Bond Interest Expense 3,431 Premium on Bonds Payable 569 Cash 4,000 (Interest Payment: 100,000 *.08 * 6/12 =4,000) (Premium amortization: (8,530  5) = 1706 per year 1706  12 months = 142 * 4 months = 569)

Extinguishment of Debt When the bonds are paid out prior to maturity Reacquisition, requires gain or loss to be recorded May be for all outstanding bonds, or a portion At 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)

Extinguishment of Debt Generally, when bonds are reacquired they are cancelled If 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 sheet Refunding of bonds: when a bond issue is called in and replaced with a new issue (at a lower rate of interest)

Extinguishment of Debt: Example Given: Existing debt:$800,000 Called and canceled at:$808,000 Unamortized discount:$ 14,400 Unamortized 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.

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

Long-Term Notes Payable and Bonds Payable: A Comparison Notes payable and bonds payable are similar in that: both have fixed maturity dates both have either stated or implicit rates Like a bond, a note payable is valued at the present value of its future interest payments and the principal (at maturity date)

A note may be issued at: face value or other than its face value When issued at other than its face value, a note may have: no interest specified (zero interest), or an interest rate less than the market rate (discount results) A discount is amortized over the note term using the effective interest method Note Issues

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 rights Then, the borrower is also the seller and the lender is also the buyer The borrower must record both: a discount on the note, and unearned revenue Example

Note Issued for Cash and Other Rights Given: Issuer gives a 5 year, $100,000 note payable to recipient company on January 1, 2000 The note is zero-interest bearing The market rate is 10 percent Recipient company has special rights to buy $500,000 of merchandise from issuer company at below market prices Journalize in issuer’s books

Note Issued for Cash and Other Rights Books of the Issuer (January 1, 2000): Cash100,000 Discount on Note Payable 37,908 Note Payable 100,000 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

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 would be: Cash (or A/R: Recipient)46,209 Unearned Revenue 3,791 Sales Revenue50,000 (Revenue recognized = $ 37,908 * ( $50,000/$500,000) = $3,791

Off-balance-sheet financing represents borrowing arrangements that are not recorded The 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) In 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 companies Off-Balance-Sheet Financing

Long-Term Debt Analysis Debt to Total Assets:Total debt Total assets Level 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 payments

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