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BONDS AND LONG-TERM NOTES

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1 BONDS AND LONG-TERM NOTES
Chapter 14 BONDS AND LONG-TERM NOTES Chapter 14: Bonds and Long-Term Notes

2 Liabilities Probable future sacrifices or economic benefits . . . . . . Arising from present obligations to other entities . . . . . . Resulting from past transactions or events. Some liabilities are not contractual obligations and may not be payable in cash. Notice that the definition of a liability involves the present, the future, and the past. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened. Liabilities are probable future sacrifices or economic benefits arising from present obligations to other entities resulting from past transactions or events. Some liabilities are not contractual obligations and may not be payable in cash. Notice that the definition of a liability involves the present, the future, and the past. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened.

3 Long-Term Debt Signifies creditors’ interest in a company’s assets.
Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates. As time passes, interest accrues on debt. Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period. Debt is reported at the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance. Long-term debt: Signifies creditors’ interest in a company’s assets. Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates. As time passes, interest accrues on debt. Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period. Debt is reported at the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance.

4 Nature of Long-Term Debt
Loan agreement restrictions Mirror image of an asset Obligations that extend beyond one year or the operating cycle, whichever is longer Long-term obligations extend beyond one year or the normal operating cycle, whichever is longer. Long-term obligations are evidenced by debt agreements called indentures. As we proceed through this material, we will perform several present value calculations in relation to bonds and long-term notes payable. Reported at present value Accrue interest expense

5 Face Value Payment at End of Bond Term
Bonds At Bond Issuance Date Company Issuing Bonds Bond Selling Price Investor Buying Bonds Bond Certificate Subsequent Periods Investor Buying Bonds Company Issuing Bonds Part I On the date the bonds are issued, the company receives the selling price of the bond, and the investor receives the bond certificate. Part II In subsequent periods, the company pays the investors interest for the use of their money. At the maturity date of the bond the company must return the face amount of the bonds to the investors. Interest Payments Face Value Payment at End of Bond Term

6 Bonds Sold at Face Amount
On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, Inc. at face amount. At Issuance (January 1) Masterwear - Issuer On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, Inc. at face amount. On the date of issuance Masterwear, the issuer, will debit Cash and credit Bonds Payable for $700,000. United, the investor, will debit Investment in Bonds and credit Cash for $700,000. United - Investor

7 Determining the Selling Price
To this point, we have assumed that bonds were sold at their face amount. This occurs only when the stated interest rate is equal to the market rate of interest. If the stated interest rate is below the market interest rate, the bonds will sell at a discount, meaning the cash received will be less than the face amount of the bonds. If the stated interest rate is above the market interest rate, the bonds will sell at a premium, meaning the cash received will be greater than the face amount of the bonds

8 Determining the Selling Price
On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup. Present value of an ordinary annuity of $1: n=6, i=7% A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity. To illustrate, On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup. To calculate the bond issue price, we multiply the semiannual interest annuity of $42,000 times , the present value of an ordinary annuity for $1 for 6 periods at 7% interest. Next we calculate the present value of the face amount of the bonds by multiplying the principal amount of $700,000 times , the present value factor of $1 for 6 periods at 7% interest. We add the two present value amount to get the present value of the bonds of $666,633. present value of $1: n=6, i=7% Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) 6 (3 x 2) semi-annual periods.

9 Journal Entries at Issuance – Bonds Issued at a Discount
Masterwear - Issuer United - Investor On the date is issuance, Masterwear, the issuer, will debit Cash for the present value amount of $666,633, debit Discount on Bonds Payable for $33,367, and credit Bonds Payable for the principal amount of $700,000. On that same date, United, the investor, will debit Investment in Bonds for the principal amount of $700,000, credit Discount on Bond Investment for $33,367, and credit cash for $666,633, the present value amount we calculated.

10 Determining Interest – Effective Interest Method
Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period). Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows: 666,633 × (14% ÷ 2) = $46,664 Outstanding Balance Effective Rate Effective Interest Part I Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period). Part II Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period, the amount is $46,664, determined by multiplying the outstanding balance of $666,633 times the effective interest rate of 7%. Part III However, the bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account). The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account).

11 Journal Entries – The Interest Method
The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period. At the First Interest Date (June 30) Masterwear - Issuer At the first interest payment date, June 30th, Masterwear, the issuer, will debit Interest Expense for $46,664, credit Discount on Bonds Payable for 4,664, and credit Cash for $42,000. On the same date, United, the investor, will debit Cash for $42,000, debit Discount on Bond Investment for $4,664, and credit Interest Revenue for $46,664. United - Investor

12 Change in Debt When Effective Interest Exceeds Cash Paid
We start the process with the balances determined at the date of issuance on January 1st . Interest of $46,664 accrues on the outstanding debt at the effective rate of 7%. Interest paid is the amount specified in the bond indenture and is determine by multiplying the stated interest rate time the face value of the bonds, or 6% times $700,000. The “unpaid” portion of the effective interest increases the existing liability and reduces the discount. The “unpaid” portion of the effective interest ($4,644) increases the outstanding balance to $671,297 and reduces the discount to $28,703 on June 30.

13 Amortization Schedule – Discount
Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt. 6% × $700,000 Part I Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt. Let’s see how this works. Part II We begin by multiplying the face amount of the bonds ($700,000) times the stated interest rate (6%) to determine the cash interest paid every six-months. Part III Next, we calculate the effective interest by multiplying the outstanding balance of the bonds ($666,633) by the effective interest rate (7%) to determine the effective interest of $46,664. Part IV The difference between the cash interest and effective interest represents the “unpaid” portion of the interest or the amount of the amortization. Part V Finally, we update the outstanding balance by adding the amortization amount to the previous outstanding balance to arrive at the new outstanding balance of $671,297. 7% × $666,633 $46,664 – 42,000 $666, ,664

14 Amortization Schedule – Discount
Here is the completed amortization schedule for the bonds issued at a discount. Review the computations to make sure you understand how the amortization schedule is developed. Amounts shown on the schedule have been rounded to the nearest dollar. $48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.

15 Zero-Coupon Bonds These bonds do not pay interest. Instead, they offer a return in the form of a “deep discount” from the face amount. Zero-coupon bonds do not pay interest; instead, they are sold at a very deep discount from face amount. As the bonds get closer to maturity, carrying value approaches face amount.

16 When Financial Statements Are Prepared Between Interest Dates
On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms: Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09 Here is the bond that we have worked with before, but in this case the stated rate of interest, 12%, is less than the market rate of interest of 14%. Will these bonds sell for a premium or a discount? You may wish to refer back to the table we prepared earlier to see the answer to this question. These bonds will be sold at a discount. Assume Masterwear and United both have September 30th year-ends.

17 When Financial Statements Are Prepared Between Interest Dates
Recall the entries we prepared on June 30, These entries will not change. Masterwear - Issuer Let’s assume that both the issuer and investor have year ends of September 30. Let’s begin the accounting process by looking at the journal entries at June 30, Masterwear will debit interest expense for $46,664, credit Discount on Bonds Payable for $4,664, and credit cash for $42,000. United, will debit cash for $42,000, debit Discount on Bond Investment $4,664, and credit interest revenue for $46,664. United - Investor

18 When Financial Statements Are Prepared Between Interest Dates
Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest for 3 months from June 30 to September 30. Masterwear - Issuer The year ended September 30, 2009, is three months from the interest payment date of June 30, We will recognize the interest for the three-month period of $23,496 (refer back to the amortization schedule to see the calculation of the second period effective interest). In addition, we will amortize the discount for the three-month period in the amount of $2,496. The issuer will debit interest expense for $23,496 credit discount on bonds payable for $2,496 and credit interest payable for $21,000. Remember the interest is not being paid; it’s merely being accrued. The investor will debit interest receivable for $21,000, debit discount on bond investment for $2,496, and credit interest revenue for $23,496. United - Investor

19 When Financial Statements Are Prepared Between Interest Dates
On December 31, the next interest payment date, the following entries would be recorded. Masterwear - Issuer On December 31, the next interest payment date, Masterwear, the issuer, will recognize an additional three months’ interest expense, an additional three months’ discount amortization, record the payment of cash, and remove the liability interest payable created by the accrual entry on September 30. Likewise, United, the investor, will recognize an additional three months’ interest revenue, an additional three months’ discount amortization, record the receipt of cash, and remove the asset interest receivable created by the accrual entry on September 30. United - Investor

20 The Straight-Line Method – A Practical Expediency
Using the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years): $33,367 ÷ 6 periods = $5,561 per period At Each of the Six Interest Dates Masterwear (Issuer) Using the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years) by dividing the total discount of $33,367 by 6 periods for a semiannual amortization of $5,561 per period. On June 30, 2009, the first interest payment date, Masterwear, the issuer, will debt interest expense of $47,561, credit discount on bonds payable for $5,561 (the amount we just calculated), and credit Cash for $42,000. United, the investor, will debit cash for $42,000, debit Discount on bonds investment for $5,561, and credit interest revenue of $47,561. Both companies will make the same journal entry each interest period. United (Investor)

21 Fair Value Option A company is not required to, but has the option to, value some or all of its financial assets and liabilities, including bonds and notes, at fair value. If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement. It’s not necessary that the company elect the option to report all of its financial instruments at fair value or even all instruments of a particular type at fair value. They can "mix and match" on an instrument-by-instrument basis. A company must make the election when the item originates and is not allowed to switch methods once a method is chosen. A company is not required to, but has the option to, value some or all of its financial assets and liabilities, including bonds and notes, at fair value. If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement. It’s not necessary that the company elect the option to report all of its financial instruments at fair value or even all instruments of a particular type at fair value. They can "mix and match" on an instrument-by-instrument basis. A company must make the election when the item originates and is not allowed to switch methods once a method is chosen.

22 Fair Value Option – Example
On July 1, HSA, Inc. issued $200,000 face value, 8% bonds, priced at $180,000 to yield an effective rate of 10% . HSA chose the fair value option for the bonds. Six months later, on December 31, HSA recorded the following interest entry: Part I To illustrate how the fair value option is applied, assume HSA, Inc. chooses the fair value option for its bonds. $200,000 of 8% bonds, priced to yield 10%, and issued for $180,000 on July 1. On December 31, HSA recorded an interest expense entry debiting interest expense for $9,000, crediting discount on bonds payable for $1,000, and crediting cash for $8,000. Part II The December 31 entry reduced the unamortized discount to $19,000 and increased the book value of the liability by $1,000 to $181,000. The December 31 entry reduced the unamortized discount to $19,000 and increased the book value of the liability by $1,000 to $181,000.

23 Fair Value Option – Example
On December 31, the fair value of the bonds was $183,000. Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account: Part I The fair value of the bonds was $183,000 on December Comparing the $183,000 fair value with the $181,000 book value on December 31 results in a $2,000 fair value adjustment. Part II Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account. The journal entry is to debit an unrealized holding loss for $2,000 and credit an account called fair value adjustment (the contra account) for the same amount. The unrealized holding loss is recognized in the current period income statement. The $2,000 credit to fair value adjustment will increase the bon credit balance to $183,000. HSA will also must recognize the unrealized holding loss in the income statement.

24 Debt Issue Costs Legal Accounting Underwriting Commission Engraving
Printing Registration Promotion Companies that issue bonds incur substantial debt issue costs. Here is a list of some of the costs that the company is likely to incur. For most companies, debt issue costs are recorded in a separate account and amortized over the life of the bond using the straight-line method.

25 The procedures are similar to those we encountered with bonds.
Long-Term Notes Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds. Long-term notes use the same present value techniques and interest recognition as bonds.

26 Long-Term Notes At Issuance
On January 1, 2009, Skill Graphics, Inc., a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31. At Issuance Skill Graphics (Borrower) To illustrate the accounting for long-term notes assume that on January 1, 2009, Skill Graphics, Inc., a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31. Skill Graphics, the borrower, will debit cash and credit notes payable for $700,000. First BancCorp, the lender, will debit notes receivable and credit cash for $700,000. First BancCorp (Lender)

27 Long-Term Notes (continued)
At Each of the Six Interest Dates Skill Graphics (Borrower) First BancCorp (Lender) At Maturity Skill Graphics (Borrower) Every six months interest is paid by Skill Graphics to First BancCorp and the journal entries shown on your screen will be made. At maturity, Skill Graphics will pay the note in full and debit notes payable and credit cash for $700,000. First BancCorp will debit cash and credit notes receivable for $700,000. First BancCorp (Lender)

28 Note Exchanged for Assets or Services
Skill Graphics purchased a package labeling machine from Hughes–Barker Corporation by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually. The machine could have been purchased at a cash price of $666,633. The cash price Implies an annual market rate of interest of 14%. That is, 7% is the semiannual discount rate that yields a present value of $666,633 for the note’s cash flows (interest plus principal) computed as follows: Present value of an ordinary annuity of $1: n=6, i=7% Now let’s assume Skill Graphics purchased a package labeling machine from Hughes–Barker Corporation by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually. Also assume that the machine could have been purchased at a cash price of $666,633. The cash purchase price of the equipment gives us an implied annual market interest rate of 14% as show in the present value computation. The accounting treatment is the same whether the amount is determined directly from the market value of the machine (and thus the note, also) or indirectly as the present value of the note (and thus the value of the asset, also). present value of $1: n=6, i=7% The accounting treatment is the same whether the amount is determined directly from the market value of the machine (and thus the note, also) or indirectly as the present value of the note (and thus the value of the asset, also).

29 Note Exchanged for Assets or Services
At the Purchase Date (January 1) Skill Graphics (Buyer/Issuer) Hughes–Barker (Seller/Lender At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Hughes–Barker (Seller/Lender Part I At the date of purchase, Skill Graphics will debit machinery for the cash purchase price of $666,633, debit Discount on notes payable for $33,337, and credit notes payable for $700,000. Hughes-Baker will debit notes receivable for $700,000, credit discount on notes receivable for $33,367, and credit sales revenue for $666,633. Part II On the first interest payment date, Skill Graphics will debit interest expense for $46,664, credit discount on notes payable for $4,664, and credit cash for $42,000. On the same date, Hughes-Barker will debit cash for $42,000, debit discount on notes receivable for $4,664, and credit interest revenue for $46,664.

30 Installment Notes To compute cash payment use present value tables.
Interest expense or revenue: Effective interest rate × Outstanding balance of debt Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period When we have an installment note, a part of each payment is applied to principal and a part is applied to interest. You can see on the screen the way we calculate the interest portion of the payment, as well as the principal reduction.

31 Installment Notes Notes often are paid in installments, rather than a single amount at maturity. $666,633 ÷ = $139, amount (from Table 4) installment of loan n=6, i=7.0% payment Notes often are paid in installments rather than a single amount at maturity. Assume that is the case with our previous example. The installment amount is determined by dividing the amount of the loan $666,633 by the present value of an ordinary annuity for 6 period at 7% ( ) to determine the periodic installment of $139,857. We subtract the effective interest from the amount of each installment to determine the decrease in the outstanding balance. For example, for the first installment payment we subtract the effective interest of $46,664 from the payment of $139,857, to get the reduction in the outstanding balance of $93,193. Now, we reduce the outstanding balance from $666,633 to $573,440. The next period interest amount is determine using the new outstanding balance of $573,440. Rounded

32 Early Extinguishment of Debt
Debt retired at maturity results in no gains or losses. BUT Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss When debt is retired at maturity, no gain or loss is recognized. If debt is retired early, that is before maturity, the company could recognize a gain or loss. A gain or loss is determined by comparing the cash proceeds to the book value of the debt.

33 Early Extinguishment Illustration – On January 1, 2010, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. $685,000 – 676,290 ($700,000 – 676,290 Part I Let’s look at the proper accounting for an early extinguishment of debt. Assume that on January 1, 2010, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. At the date of early extinguishment, we will eliminate the bonds payable by crediting that account for $700,000, and we will eliminate the unamortized discount on bonds payable with a credit of $23,710. You may wish to refer back to the amortization schedule developed earlier in this discussion. Next, we will credit cash for the call price of $685,000. Finally, we will recognize the loss on early extinguishment of $8,710, the difference between the call price of the bonds and the outstanding balance on the date of retirement. Part II The FASB requires that the gain or loss be classified in the income statement as an extraordinary item only if the situation meets the usual criteria of being both unusual and infrequent. The FASB requires that the gain or loss be classified in the Income Statement as an extraordinary item only if the situation meets the usual criteria of being both unusual and infrequent.

34 Financial Statement Disclosures
Long-Term Debt For all long-term debt, disclosures should include the aggregate amount maturing in each of the next five years, as well as any sinking fund payments required. For all long-term borrowing, disclosures should include the aggregate amounts maturing and sinking fund requirement, if any, for each of the next five years.

35 Decision Makers’ Perspective
Long-term debt impacts several key financial ratios. Rate of return on shareholders’ equity Net income Shareholders’ equity = Times interest earned ratio = Net income + interest + taxes Interest Here are four significant ratios that help us determine the impact of long-term debt on the financial statements of the company. Debt to equity ratio Total liabilities Shareholders’ equity = Rate of return on assets Net income Total assets =

36 Convertible Bonds Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer updates interest expense and amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased. Some bonds have a provision permitting the holder to convert the bonds into common shares. When the bonds are converted they must be removed from the books along with any unamortized discount or premium at the date of conversion. Along with the reduction in the bonds, we have an increase in the number of common shares outstanding. Bonds into Stock

37 Induced Conversion Companies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a “call” provision. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the shares rather than the lower call price. Companies can induce conversion of debt through the use of call provisions. When the call price is less than the market price of the bonds, the bondholders will be induced to convert their bonds into common stock or suffer a loss.

38 Bonds With Detachable Warrants
Stock warrants provide the option to purchase a specified number of shares of common stock at a specified option price per share within a stated period. A portion of the selling price of the bonds is allocated to the detachable stock warrants. Some bonds are issued with detachable stock purchase warrants. A detachable warrant gives the holder the right to purchase a share of common stock by relinquishing the warrant. When bonds are issued with detachable warrants, a portion of the proceeds received from the sale of the bonds is assigned to the detachable stock warrants.

39 Bonds With Detachable Warrants
Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16. Part I Here is an example of a bond issued with detachable stock purchase warrants. We will allocate the proceeds on the basis of relative fair value. Part II The relative fair value of the bonds without the warrants is 98.39% of the total. The fair value of the warrants without the bonds is 1.61% of the total. You can see that we allocate the $10 million face amount between the bonds and the warrants. Now let’s look at the journal entry to record this transaction.

40 Troubled Debt Restructuring - Appendix
Troubled debt may be restructured in one of two ways: Troubled debt may be restructured in one of two ways. The debt can be fully settled at the time of restructuring, or modifications to terms of the existing debt can be made and the debt will continue. Settled at time of restructuring. Continued with modified terms.

41 Troubled Debt Restructuring - Appendix
Settled at time of restructuring. Book value of the debt – Fair value of asset transferred Gain on restructuring When the debt is settled at the time of restructuring, the debtor normally recognizes a gain. The gain is measured by the difference between the book value of the debt and the fair value of the assets transferred to the creditor. Because the debtor is in financial difficulty, the fair value of the assets transferred is generally less than the book value of the debt. Debtor reports ordinary gain or loss on adjustment to fair value of the asset transferred.

42 Troubled Debt Restructuring - Appendix
Continued with modified terms. Reduce or delay interest payments. Reduce or delay maturity payment. When we have a modification of terms and a continuation of the debt, we normally see a reduction in the interest payments and a reduction in the principal amount due. Accounting treatment depends upon the total future cash inflows that will be received by the creditor. Accounting treatment depends on a comparison of total cash payments after restructuring with the book value of the original debt.

43 Troubled Debt Restructuring
Continued with modified terms. Cash payments less than book value of debt. Cash payments more than book value of debt. Debtor reports difference as a gain. All cash payments are reductions in principal. (No interest) No gain reported. Compute new effective interest rate. Record annual interest at new rate. If the future cash payments are less than the book value of the debt, the debtor generally recognizes a gain on restructuring, and any future cash payments represent a reduction in principal. There is no interest expense recognized. When the future cash payments are more than the book value of the debt, no gain is recognized. We must calculate a new effective interest rate that will equate the future cash flows with the book value of the debt. Future interest recognized is based upon this new interest rate.

44 End of Chapter 14. End of Chapter 14


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