Accounting Chapter 14 Homework Teaching Transparency Masters The Following Can Reproduced

CHAPTER 14

Bonds and Long-Term Notes

Overview

This chapter continues the presentation of liabilities. Specifically, the discussion focuses on the

accounting treatment of long-term liabilities. Long-term notes and bonds are discussed, as well as

the extinguishment of debt and troubled debt restructuring.

Learning Objectives

LO14-1 Identify the underlying characteristics of debt instruments and describe the basic

approach to accounting for debt.

LO14-2 Account for bonds issued at par, at a discount, or at a premium, recording interest at the

effective rate or by the straight-line method.

LO14-3 Characterize the accounting treatment of notes, including installment notes, issued for

cash or for noncash consideration.

LO14-4 Describe the disclosures appropriate to long-term debt in its various forms.

LO14-5 Record the early extinguishment of debt and its conversion into equity securities.

LO14-6 Understand the option to report liabilities at their fair values.

LO14-7 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting

for bonds and long-term notes.

Lecture Outline

Part A: Bonds

I. Nature of Long-Term Debt (T14-1)

A. Liabilities signify creditors’ interest in a company’s assets.

B. Debt requires the future payment of cash in specified (or estimated) amounts, at specified

(or projected) dates.

C. As time passes, interest accrues on debt.

D. Periodic interest is the effective interest rate times the amount of the debt outstanding

during the interest period.

E. Reported at present value of its related cash flows (principal and/or interest payments),

discounted at the effective rate of interest at issuance.

II. Bonds

A. Divide a large liability into many smaller liabilities (usually $1,000 per bond).

B. Obligate a company to repay a stated amount at a specified maturity date and periodic

interest between the issue date and maturity.

C. Require periodic interest as a stated percentage of the face amount.

D. Pay interest semiannually (usually) on designated interest dates beginning six months after

the day the bonds are “dated”

14-2 Intermediate Accounting, 8/e

E. Make specific promises to bondholders who are described in a document called a bond

indenture. (T14-2)

F. Represent a liability to the corporation that issues the bonds and an asset to a company that

buys the bonds as an investment. (T14-3)

Issuer

Cash ………………………………………………………………………… xxx

Bonds payable (face amount)………………………………. xxx

Investor

Investment in bonds (face amount) ………………………………. xxx

Cash…………………………………………………………………. xxx

III. Pricing of Bonds (T14-4)

A. Supply and demand cause a bond to be priced to yield the market rate of interest for

securities of similar risk and maturity.

1. Price can be calculated as the present value of all the cash flows required (principal

and interest).

2. The discount rate is the market rate.

B. Other things being equal, the lower the perceived riskiness of the corporation issuing

bonds, the higher the price those bonds will command.

C. When bond prices are quoted in financial media, they typically are stated in terms of a

percentage of face amount. So, a price quote of 97 means a $1,000 bond will sell for

$970; a bond priced at 102 will sell for $1,020.

IV. Interest

A. Interest accrues at the effective market rate of interest multiplied by the outstanding

balance (during the interest period). (T14-5)

B. When only a portion of an expense is paid by the periodic cash interest payment, the

remainder becomes a liability (or an addition to the already outstanding liability). So the

difference increases the liability and is reflected as a reduction in the discount (a valuation

account). (T14-6)

C. Because the balance of the debt changes each period, the dollar amount of interest

(balance x rate) also will change each period. To keep up with the changing amounts, it

usually is convenient to prepare a schedule that reflects the changes in the debt over its

term to maturity. (T14-7)

D. If an accounting period ends between interest dates, it is necessary to record interest that

has accrued since the last interest date. (T14-8)

E. Alternatively, a company is permitted to allocate a discount or a premium equally to each

period over the term to maturity if doing so produces results that are not materially

different from the interest method. (T14-9)

V. Zero-Coupon Bonds

A zero-coupon bond pays no interest but, instead, offers a return in the form of a “deep

discount” from the face amount.

VI. Debt Issue Costs Are Incurred in Connection with Issuing Bonds or Notes (T14-10)

A. They include legal and accounting fees and printing costs in addition to registration and

underwriting fees.

B. Costs of issuing debt securities are recorded as a debit to an asset account, “debt issue

costs.”

C. The cost is amortized to expense over the term to maturity.

Part B: Long-Term Notes

I. Accounting for Notes

A. In concept, notes are accounted for in precisely the same way as bonds. (T14-11)

B. When a note is issued with an unrealistic interest rate, the effective market rate is used

both to determine the amount recorded in the transaction and to record periodic interest

thereafter. (T14-12)

1. Substance over form.

2. Accounting treatment is the same whether the amount is determined directly from the

market value of the asset acquired (and thus the note, also) or indirectly as the present

value of the note (and thus the value of the asset.

3. Also, both parties to the transaction should record periodic interest (interest expense

to the borrower, interest revenue to the lender) at the effective rate, rather than the

stated rate.

C. Installment notes are paid in installments, rather than by a single amount at maturity.

(T14-13)

1. Installment payments are equal amounts each period.

2. Each payment includes both an amount that represents interest and an amount that

represents a reduction of principal.

3. The periodic reduction of principal is sufficient that, at maturity, the note is

completely paid.

4. The installment amount is easily calculated by dividing the amount of the loan by the

appropriate discount factor for the present value of an annuity.

II. Financial Statement Disclosure (T14-14)

A. On the balance sheet, disclosure should include, for all long-term borrowings, the aggregate

amounts maturing and sinking fund requirements (if any) for each of the next five years.

B. Supplemental disclosures are needed for:

1. Off-balance-sheet credit or market risk.

2. Concentrations of credit risk.

3. The fair value of financial instruments.

Decision-Makers’ Perspective

A. Failure to properly consider risk in business decisions is one of the most costly, yet one of

the most common, mistakes investors and creditors can make.

B. Long-term debt is one of the first places decision makers should look when trying to get a

handle on risk.

14-4 Intermediate Accounting, 8/e

C. Generally speaking, debt increases risk.

1. The debt to equity ratio, total liabilities/shareholders’ equity, often is calculated to

measure the degree of risk.

2. Other things being equal, the higher the debt to equity ratio, the higher the risk.

D. Debt also can be an advantage by enhancing the return to shareholders.

1. This concept is known as leverage.

2. “Favorable financial leverage” occurs when a company earns a return on borrowed

funds in excess of the cost of borrowing the funds, shareholders are provided with a

total return greater than what could have been earned with equity funds alone.

E. Failure to pay interest as scheduled may cause several adverse consequences including

bankruptcy.

1. One way to measure a company’s ability to pay its obligations is by comparing interest

payments with income available to pay those charges.

2. The times interest earned ratio is determined by dividing income before subtracting

interest expense or income tax expense by interest expense.

F. “Off-balance-sheet” financing and other commitments can increase risk.

Part C: Debt Retired Early, Convertible into Stock, or Providing an Option to

Buy Stock

I. Early Extinguishment of Debt

A. A gain or loss on early extinguishment of debt should be recorded for the difference

between the reacquisition price and the book value of the debt.

B. The gain or loss should be classified on the income statement as an extraordinary item only

if it meets criteria for such reporting by being both (1) unusual and (2) infrequent.(T14-15)

II. Convertible Debt

A. Convertible bonds are accounted for as straight debt.

B. Stock or other financial instruments that a company is obligated to buy back (manditorily

redeemable), must be reported in the balance sheet as a liability, not as shareholders’

equity.

III. Bonds With Detachable Warrants

The value of the equity feature is recorded separately for bonds issued with detachable

warrants.

Part D: Fair Value Option

I. 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.

II. If a company chooses the option to report at fair value, then it reports changes in

fair value as OCI (net of tax) in its statement of other comprehensive income.

(T14-16)

IV. International Financial Reporting Standards

A. Differences in the definitions and requirements under these standards can result in the

same instrument being classified differently between debt and equity under IFRS and

U.S. GAAP. Most preferred stock (preference shares) is reported under IFRS as debt

with the dividends reported in the income statement as interest expense. Under U.S.

GAAP, that’s the case only for “manditorily redeemable” preferred stock. (T14-17)

B. Under IFRS, convertible debt is divided into its liability and equity elements. Under US

GAAP, the entire issue price is recorded as debt. (T14-18)

Appendix A: Bonds Issued between Interest Dates

A. All bonds sell at their price plus any interest that has accrued since the last interest date.

(T14-19)

B. face annual fraction of the accrued

value x rate x annual period = interest

Appendix B: Troubled Debt Restructuring

A. The way a troubled debt restructuring is recorded depends on whether

1. The debt is settled at the time of the restructuring, or (T14-20)

2. The debt is continued, but with modified terms where the total cash to be paid

a. Is less than the book value of the debt or (T14-21)

b. Exceeds the book value of the debt. (T14-22)

14-6 Intermediate Accounting, 8/e

PowerPoint Slides

A PowerPoint presentation of the chapter is available at the textbook website.

Teaching Transparency Masters

The following can be reproduced on transparency film as they appear here, or

you can use the disk version of this manual and first modify them to suit your

particular needs or preferences.

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.

 Reported at present value of its related cash flows (principal

and/or interest payments), discounted at the effective rate of

interest at issuance.

T14-1

14-8 Intermediate Accounting, 8/e

BONDS

Debenture bond – secured only by the “full faith and credit” of

the issuing corporation. No specific assets are pledged as security.

Mortgage bond – backed by a lien on specified real estate

owned by the issuer.

Subordinated debenture – not entitled to receive any

liquidation payments until the claims of other specified debt issues

are satisfied.

Registered bond – interest checks are mailed directly to the

owner, who is “registered” with the issuing company.

Callable (or redeemable) bonds – the call feature allows the

issuing company to buy back, or “call”, outstanding bonds from

bondholders before their scheduled maturity date.

Serial bonds – retired in installments over all or part of the life

of the issue. Each bond has its own specified maturity date.

Convertible bonds – retired as a consequence of bondholders

choosing to convert them into shares of stock.

BONDS SOLD AT FACE AMOUNT

On January 1, 2016, 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)

T14-3

14-10 Intermediate Accounting, 8/e

DETERMINING THE SELLING PRICE

A bond issue will be priced by the marketplace to yield the

market rate of interest for securities of similar risk and maturity.

Illustration – On January 1, 2016, Masterwear Industries issued

$700,000 of 12% bonds, dated January 1. Interest is payable

Present value (price) of the bonds:

Present Values

Interest $42,000 x 4.76654 * = $200,195

Note: Because interest is paid semiannually, the present value calculations use: (a)

T14-4

JOURNAL ENTRIES AT ISSUANCE –

BONDS SOLD AT DISCOUNT

Masterwear (Issuer)

Cash (price calculated above) …………………………. 666,633

T14-4 (continued)

14-12 Intermediate Accounting, 8/e

DETERMINING INTEREST –

EFFECTIVE INTEREST METHOD

 Interest accrues on an outstanding debt at a constant

percentage of the debt each period. Interest each period is

Continuing the previous example, interest recorded (as expense

to the issuer and revenue to the investor) for the first six-month

interest period is $46,664:

CHANGE IN DEBT WHEN

EFFECTIVE INTEREST EXCEEDS CASH PAID

 The “unpaid” portion of the effective interest increases the

existing liability.

ACCOUNT BALANCES

OUTSTANDING Bonds payable Discount on

BALANCE (face value) bonds

T14-6

14-14 Intermediate Accounting, 8/e

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)

T14-6 (continued)

AMORTIZATION SCHEDULE – DISCOUNT

Since less cash is paid each period than the effective interest,

the unpaid difference increases the outstanding balance of the debt.

Cash Effective Increase in Outstanding

Interest Interest Balance Balance

6% x Face Value 7% x Outstanding Debt Discount Reduction

1/01/16 666,633

6/30/16 42,000 .07 (666,633) = 46,664 4,664 671,297

T14-7

14-16 Intermediate Accounting, 8/e

When Financial Statements Are Prepared

Between Interest Dates

When an accounting period ends between interest dates, it is

necessary to record interest that has accrued since the last interest

date. For instance, if the fiscal years of Masterwear and United

At October 31

Masterwear (Issuer)

Interest expense (4/6 x 46,991) …………………………….. 31,327

When Financial Statements Are Prepared

Between Interest Dates

(continued)

Two months later, when semiannual interest is paid next, the

remainder of the semiannual interest is allocated to the first two

months of the next accounting year – November and December:

At the December 31 Interest Date

Masterwear (Issuer)

Interest expense (2/6 x 46,991) …………………………….. 15,664

T14-8 (continued)

14-18 Intermediate Accounting, 8/e

THE STRAIGHT-LINE METHOD –

A PRACTICAL EXPEDIENCY

By the straight-line method, the discount in the earlier

illustration would be allocated equally to the 6 semiannual periods

(3 years):

At Each of the Six Interest Dates

Masterwear (Issuer)

Interest expense (to balance) ……………………………….. 47,561

T14-9

DEBT ISSUE COSTS

With either publicly or privately sold debt, the issuing

company will incur costs in connection with issuing bonds or

notes, such as legal and accounting fees and printing costs in

addition to registration and underwriting fees. These debt issue

costs are recorded separately and are amortized over the term of

the related debt.

T14-10

14-20 Intermediate Accounting, 8/e

Long-Term Notes

On January 1, 2016, 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)

T14-11