Acct 322 Lecture Notes Chapter 14: Long-Term Liabilities

1. Describe the formal procedures associated with issuing long-term debt. (S.O. 1) Long-term debt consists of obligations that are not payable within the operating cycle or one year, whichever is longer. These obligations normally require a formal agreement between the parties involved that often includes certain covenants and restrictions for the protection of both lenders and borrowers. These covenants and restrictions are found in the bond indenture or note agreement, and include information related to amounts authorized to be issued, interest rates, due dates, call provisions, security for the debt, sinking fund requirements, etc. The important issues related to the long-term debt should always be disclosed in the financial statements or the notes thereto. Long-term liabilities include bonds payable, mortgage notes payable, long-term notes payable, lease obligations, and pension obligations. Pension and lease obligations are discussed in later chapters. 2. Identify various types of bond issues. Term Bonds Serial Bonds Secured & Unsecured Bonds Convertible Bonds Commodity Backed Bonds Deep Discount Bonds Registered Coupon Bonds

3. Describe the accounting valuation for bonds at date of issuance. (S.O. 3) Bonds are issued with a stated rate of interest expressed as a percentage of the face value of the bonds. When bonds are sold for more than face value (at a premium) or less than face value (at a discount), the interest rate actually earned by the bondholder is different from the stated rate. This is known as the effective yield or market rate of interest and is set by economic conditions in the investment market. The effective rate exceeds the stated rate when the bonds sell at a discount, and the effective rate is less than the stated rate when the bonds sell at a premium. Valuation. The price of a bond is determined by the interaction between the bond's stated interest rate and its market rate. a. b. c. d. A bond's price is equal to the sum of the present value of the principle and the present value of the periodic interest. If the stated rate = the market rate, the bond will sell at par. If the stated rate < the market rate, the bond will sell at a discount. If the stated rate > the market rate, the bond will sell at a premium.

To compute the effective interest rate of a bond issue, the present value of future cash flows from interest and principal must be computed. This often takes a financial calculator or computer to calculate.
Example 1: 10% 5-Year $1000 bond. The Market rate is 12%, what is the Premium or discount. FV = -1000; PMT = -100; N = 5; I/Y = 12; CPT PV = 982.14; Discount = $17.86 Example 2: 6% 5-Year $100,000 bonds. The Market rate is 4.5%, what is the Premium or discount. FV = -100000; PMT = -6000; N = 5; I/Y = 4.5; CPT PV = 106,584.97; Discount = $6,584.97

4. Apply the methods of bond discount and premium amortization. (S.O. 4) Discounts and premiums resulting from a bond issue are recorded at the time the bonds are sold. The amounts recorded as discounts or premiums are amortized each time bond interest is paid. The time period over which discounts and premiums are amortized is equal to the period of time the bonds are outstanding (date of sale to maturity date). Amortization of bond premiums decreases the recorded amount of bond interest expense, whereas the amortization of bond discounts increases the recorded amount of bond interest expense. Bond discounts or premiums may be amortized using the straight-line method. However, the profession's preferred procedure is the effective interest method. This method computes the bond interest using the effective rate at which the bonds are issued. More specifically, interest cost for each period is the effective interest rate multiplied by the carrying value (book value) of the bonds at the start of the period. The effective interest method is best accomplished by preparing a Schedule of Bond Interest Amortization. This schedule provides the information necessary for each semiannual entry for interest and discount or premium amortization. Unamortized premiums and discounts are reported with the Bonds Payable account in the liability section of the balance sheet. Premiums and discounts are not liability accounts; they are merely liability valuation accounts. Premiums are added to the Bonds Payable account and discounts are deducted from the Bonds Payable account in the liability section of the balance sheet. If the interest payment date does not coincide with the financial statement's date, the amortized premium or discount should be prorated by the appropriate number of months to arrive at the proper interest expense. Some of the costs associated with issuing bonds include engraving and printing costs, legal and accounting fees, commissions, and promotion expenses. APB Opinion No. 21, "Interest on Receivables and Payables," indicates that these costs should be debited to a deferred charge account entitled, Unamortized Bond Issue

Costs. These costs are then amortized over the life of the issue in a manner similar to that used for discount on bonds.
Recording Issuance Examples If Aretha Company issued $100,000 of bonds dated January 1, 2004 at 98, on January 1, 2004, the entry would be as follows: Cash ($100,000 x.98) Discount on Bonds Payable Bonds 100,000 98,000 2,000

If the same bonds noted above were sold for 102 the entry to record the issuance would be as follows: Cash ($100,000 x 1.02) Premium on Bonds Payable Bonds Payable 102,000 2,000 100,000

It should be noted that whenever bonds are issued, the Bonds Payable account is always credited for the face amount of the bonds issued. Amortization Entry Examples (straight line) Assume the bonds sold in the example in paragraph 10 above are five-year bonds. Since the bonds are sold on the issue date (January 1, 2004), they will be outstanding for the full five years. Thus, the discount or premium would be amortized over the entire life of the bonds. The entry to amortize the bond discount at the end of 2004 would be: Bond Interest Expense Discount on Bonds Payable ($2,000/5) The entry to amortize the premium would be: Premium on Bonds Payable Bond Interest Expense 400 400 400 400

Example Issuance Between Interest Dates When bonds are issued between interest dates, the purchase price is increased by an amount equal to the interest earned on the bonds since the last interest payment date. On the next interest payment date, the bondholder receives the entire semiannual interest payment. However, the amount of interest expense to the issuing corporation is the difference between the semiannual interest payment and the amount of interest prepaid by the purchaser. For example, assume a 10-year bond issue in the amount of $300,000, bearing 9% interest payable semi-annually, dated January 1, 2004. If the entire bond issue is sold at par on March 1, 2004, the following journal entry would be made by the seller: Cash Bonds Payable Bond Interest Expense *($300,000 x .09 x 1/6) 304,500 300,000 4,500*

Computation of AmortizationStraight-Line Method

Bond Discount or Premium =

Number of Interest Periods

Bond Amortization

Interest Payable = Constant Amount Constant Amount

+Discount Premium Amortization

Interest Expense Constant Amount

ILLUSTRATION 14-2 BOND AMORTIZATION METHODS

Computation of AmortizationEffective Interest Method

Bond Interest Payable Face Stated Amount Interest of Bonds Rate Bonds Interest Expense Carrying Effective Value Interest of Bonds Rate Beginning of Period PremiumDecreasing Amount DiscountIncreasing Amount = Amortization Amount

Treasury bonds are a corporation's own bonds that have been reacquired but not canceled. They should be shown on the balance sheet at their par value as a deduction from the bonds payable issued to arrive at bonds payable outstanding.
Constant Amount Decreasing Amount Increasing Amount

ILLUSTRATION 14-3 ACCOUNTING FOR BONDS

Three-year bond with an 8% coupon rate sold to yield 10% on January 1, 2004. Interest payable annually on December 31. Callable at 105. Face value: $100,000. Bond issue costs: $5,000. 1. Calculation of premium or discount. $100,000 (0.75132) = $75,132 (Present value of principal, Table 6-2) $ 8,000 (2.48685) = 19,895 (Present value of interest, Table 6-4) $95,027 (Selling price of bond) Discount = $100,000 $95,027 = $4,973. 2. Recording of bond issuance. Cash. Bond Issue Costs Discount on Bonds Bonds Payable. 3. Bond Discount Amortization. Interest Interest Pay. (8%) Expense (10%) 01/01/04 12/31/04 12/31/05 12/31/06 8,000 8,000 8,000 9,503 9,653 9,817 Discount Bond Face Val. Amortization Discount of Bonds 1,503 1,653 1,817 4,973 3,470 1,817 0 100,000 100,000 100,000 100,000 Car. Val. of Bonds 95,027 96,530 98,183 100,000

90,027 5,000 4,973 100,000

4. Accounting entries. 12/31/04 Interest Expense Discount on Bonds Cash Bond Issue Expense Bonds Issue Costs Bonds Payable Cash 9,503 1,503 8,000 1,667 1,667 1,667 1,667 100,000 100,000 12/31/05 9,653 1,653 8,000 1,666 1,666 12/31/06 9,817 1,817 8,000

5. Describe the accounting procedures for the extinguishment of debt. (S.O. 5) The extinguishment, or payment, of long-term liabilities can be a relatively straightforward process which involves a debit to the liability account and a credit to cash. The process can also be a complicated one when the debt is extinguished prior to maturity.

The reacquisition of debt can occur either by payment to the creditor or by reacquisition in the open market. At the time of reacquisition, any unamortized premium or discount, and any costs of issue related to the bonds, must be amortized up to the reacquisition date. If this is not done, any resulting gain or loss on the extinguishment would be misstated. The difference between the reacquisition price and the net carrying amount of the debt is a gain (reacquisition price lower) or loss (reacquisition price greater). ILLUSTRATION 14-4 EXTINGUISHMENT OF DEBT

Three year 8% bonds of $100,000 are recalled at 105 on December 31, 2005. Expenses of recall: $2,000.

General ledger account balances at 12/31/05:

Bond Issue Cost
1/1/04 $5,000 12/31/04 12/31/05 $1,667 1,667

Bonds Payable
12/31/05 $100,000

Bal. 12/31/01

$1,666

Discount on Bonds Payable

1/1/04 $4,973 12/31/04 12/31/05 $1,503 1,653

Bal. 12/31/05

$1,817

ANALYSIS: Cash paid Net carrying amount of bonds Loss on extinguishment = (1.05 $100,000) + $2,000 = $107,000. = ($100,000 $1,817 $1,666) = $96,517. = $107,000 $96,517 = $10,483.

JOURNAL ENTRY: Bonds Payable Loss on Extinguishment Cash. Discount on Bonds. Bond Issue Costs 100,000 10,483 107,000 1,817 1,666

6. Explain the accounting procedures for long-term notes payable. (S.O. 6) The difference between current notes payable and long-term notes payable is the maturity date. Accounting for notes and bonds is quite similar. Interest-bearing notes are treated the same as bondsa discount or premium is recognized if the stated rate is different than the effective rate. Zero-interestbearing notes represent a discount on the note and the discount is amortized similar to the manner as discounts on interest-bearing notes.
Long-Term Notes Payable. 1. Application of APB Opinion No. 21 insures proper accounting for transactions where the form does not reflect the economic substance of the arrangement, because of failure to provide for a realistic interest rate on amounts payable or receivable. Notes not issued at face value a. Zero Interest-Bearing Notes Issued for Cash: (1) The implicit interest rate is the rate that equates the cash received (present value) with the amounts received in the future. (2) The difference between the face amount and the present value of the note is the discount or premium and it is amortized over the life of the note. Interest-Bearing Notes with an Effective Rate Different than the Stated Rate: (1) If a stated interest rate is unreasonable, an imputed interest rate must be used to determine the present value of the note. (2) Any discount or premium must be recognized and amortized over the life of the note.

2.

b.

3.

Special note payable situations a. Non-cash transactions: the present value of the debt is measured by the fair value of the property, goods, or services changing hands or by an amount that reasonably approximates the market value of the note. When a debt instrument is exchanged for noncash consideration in a bargained transaction, the stated rate of interest is presumed fair unless: (a) no interest rate is stated, (b) the stated rate is unreasonable, or (c) the face amount of the debt instrument is materially different from the current cash price of the consideration or the current market value of the debt instrument. b. Imputing an interest rate: (1) the rate that would have resulted if an independent borrower and lender had negotiated a similar transaction. (2) When interest is imputed, the effective interest method has to be used. (3) If the stated rate is determined to be inappropriate, an imputed interest rate must be used to establish the present value of the debt instrument. The imputed interest rate is used to establish the present value of the debt instrument by discounting, at that rate, all future payments on the debt instrument.

4.

Journal entries are similar to entries for bonds payable issued at a discount.

5.

Mortgage Notes Payable: Mortgage notes are a common means of financing the acquisition of property, plant, and equipment in a proprietorship or partnership form of business organization. Normally, the title to specific property is pledged as security for a mortgage note. Points raise the effective interest rate above the stated rate. If a mortgage note is paid on an installment basis, the current installment should be classified as a current liability. a. b. c. A promissory note secured by property. Usually receive cash equal to face value of the note. If lender assesses points, borrower receives less than face value of the note. (1) A point equals 1% of the notes' face value. (2) Record as a note with a discount. Discuss fixed-rate vs. variable-rate mortgages: Because of unusually high, unstable interest rates and a tight money supply, the traditional fixed-rate mortgage has been partially supplanted with new and unique mortgage arrangements. Variable-rate mortgages feature interest rates tied to changes in the fluctuating market rate of interest. Generally, variable-rate lenders adjust the interest rate at either one or three-year intervals.

d.

7. Explain the reporting of off-balance sheet financing arrangements. (S.O. 7) A significant issue in accounting today is the question of off-balancesheet financing. Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded. Off-balance-sheet financing can take many different forms. Some examples include (1) non-consolidated subsidiary, (2) a special purpose entity, and (3) operating leases. The FASB response to off-balance-sheet financing arrangements has increased disclosure (note) requirements. Off-balance sheet financing: an attempt to borrow in such a way that the obligation is not recorded. Examples Include: 1. Non-consolidated subsidiary. a. GAAP does not require a subsidiary that is less than 50% owned to be included in the consolidated financial statements. (1) Any liabilities are reported on the subsidiarys balance sheet, not the parent companys. Special purpose entity (SPE). a. An entity created by a company to perform a special project. b. The SPE reports any liabilities on its books. Operating leases. a. Lease assets instead of buying them and incurring debt to finance the purchase. Rationale for off-balance sheet financing. a. Attempt to "enhance the quality" of the balance sheet. b. Conform to loan covenants.

2.

3.

4.

c. Balance" understatement of assets. FASBs response has been to require increased not disclosure.

8. Indicate how long-term debt is presented and analyzed. Presentation of Long-Term Debt (S.O. 8) Companies that have large amounts and numerous issues of long-term debt frequently report only one amount in the balance sheet and support this with comments and schedules in the accompanying notes to the financial statements. Foot note disclosures generally indicate: the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by the borrower, and assets pledged as security. Long-term debt that matures within one year: should be reported as a current liability unless retirement is to be accomplished with other than current assets.

Analysis of Long-Term Debt Long-term creditors and stockholders are interested in a company's long-run solvency and the ability to pay interest when it is due. Two ratios that provide information about debt-paying ability and long-run solvency are the debt to total assets ratio and the times interest earned ratio.

ILLUSTRATION 14-5 DEBT TO TOTAL ASSETS AND TIMES INTEREST EARNED RATIOS

DEBT TO TOTAL ASSETS AND TIMES INTEREST EARNED RATIOS Debt to total assets ratio = Total debt Total assets

Times interest earned ratio = Income before interest and taxes Interest expense Example (in millions of dollars): Total assets Total liabilities Net income $ 2,515 1,509 200 Interest expense Income taxes $ 3.5 123.0

Debt to total assets = $ 1,509 = 60% $ 2,515 Times interest earned = $ 200 + $ 3.5 + $123 = 93 times $ 3.5