Long-Term Liabilities | Bonds | Intermediate Accounting | CPA Exam FAR | Chapter 14

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This chapter covers accounting for bonds issued at discount or premium, long term notes payable using effective interest rate for amortization.

Introduction to Bonds

Bond Issue at Par | Valuation of Bonds Payable

Bond Issue at Discount & Premium | Straight-Line Method Amortization

Bond Issue at Discount & Premium | Effective-Interest Rate Amortization

Bond Retirement | Extinguishment of Debt

Long-Term Notes Payable

Fair Value Option For Financial Assets & Liabilities

Troubled-Debt Restructuring: Settlement of Debt (Appendix 14A #1)

Troubled-Debt Restructuring: Modification of Terms (Appendix 14A #2)

Example BE 14-1 (Whiteside Co): Compute Issue Price of a Bond

Example BE 14-2 (Colson Co): Bond Issue at Par

Example BE 14-3 (Colson Co): Bond Issue at Discount

Example BE 14-4 (Colson Co): Bond Issue at Premium

Example BE 14-5 (Devers Co): Bond Issue Between Interest Payments

Example BE 14-7 (JWS Corp): Premium Bond Amortization

Example BE 14-11 (Henderson Corp): Debt Retirement

Example BE 14-14 (McCormick): Issue Non-Interest Bearing Note to Buy an Asset

Chapter 14 presents a discussion of the issues related to long-term liabilities. Long-term debt consists of probable future sacrifices of economic benefits. These sacrifices are payable in the future, normally beyond one year or the operating cycle, whichever is longer. Coverage in this chapter includes bonds payable, long-term notes payable, mortgages payable, and issues related to extinguishment of debt. The accounting and disclosure issues related to long-term liabilities include a great deal of detail due to the potentially complicated nature of debt instruments.

Long-Term Debt

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.

Issuing Bonds

Bonds payable represent an obligation of the issuing corporation to pay a sum of money at a designated maturity date plus periodic interest at a specified rate on the face value. The main purpose of issuing bonds is to borrow for the long term when the amount of capital needed is too large for one lender to supply. Bond interest payments are usually made semiannually.

Bonds are debt instruments of the issuing corporation used by that corporation to borrow funds from the general public or institutional investors. The use of bonds provides the issuer an opportunity to divide a large amount of long-term indebtedness among many small investing units.

Bonds may be sold through an underwriter who either (a) guarantees a certain sum to the corporation and assumes the risk of sale or (b) agrees to sell the bond issue on the basis of a commission. Alternatively, a corporation may sell the bonds directly to a large financial institution without the aid of an underwriter.

Types of Bonds

There are various types of bonds that can be issued, to include: term bonds, serial bonds, callable bonds, secured and unsecured bonds, convertible bonds, commodity-backed bonds, deep discount bonds, registered and coupon bonds, and income and revenue bonds.

Valuation and Accounting for Bonds Payable

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. The issue price is based on 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.

To compute the issue price of bonds, the present value of future cash flows from interest and principal must be computed.

Bonds Issued at a Discount or Premium

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).

To illustrate the recording of bonds sold at a discount or premium, the following examples are presented. If Aretha Company issued $100,000 of bonds dated January 1, 2017 at 98, on January 1, 2017, the entry would be as follows:

Cash ($100,000 × .98)…………………………………                 98,000

Discount on Bonds Payable……………………….                   2,000

Bonds Payable………………………………………                                       100,000

f the same bonds noted above were sold for 102, the entry to record the issuance would be as follows:

Cash ($100,000 × 1.02)………………………………………….. 102,000

Premium on Bonds Payable…………………………………………..                2,000

Bonds Payable……………………………………………………………….           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.

Straight-Line Amortization of Discount and Premium

To illustrate the amortization of the bond discount or premium, assume the bonds sold in the example above are five-year bonds, and they pay interest annually. Since the bonds are sold on the issue date (January 1, 2017) 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 2017 is:

Interest Expense……………………………………………..                  400

Discount on Bonds Payable ($2,000 ÷ 5)….                                          400

The entry to amortize the premium is:

Premium on Bonds Payable……………………………                  400

Interest Expense ……………………………………….                                          400

Note that the amortization of the discount increases the interest expense for the period and the amortization of the premium reduces interest expense for the period.

Bonds Issued 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. As a result, 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 semiannually on June 30 and December 31, dated January 1, 2017. If the entire bond issue is sold at par on March 1, 2017, the following journal entry will be made by the seller:

Cash………………………………………………………………………. 304,500

Bonds Payable……………………………………………………………….           300,000

Interest Expense…………………………………………………………….                4,500*

*($300,000 × .09 × 2/12)

The entry for the semiannual interest payment on July 1, 2017 would be as follows:

Interest Expense………………………………………………………. 13,500

Cash……………………………………………………………………………….             13,500

The total bond interest expense for the six month period is $9,000 ($13,500 – $4,500), which represents the correct interest expense corresponding to the four-month period the bonds were outstanding.

Effective-Interest Amortization

The profession’s preferred procedure to amortize discounts and premiums 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. The chapter includes an illustration of a Schedule of Bond Interest Amortization for both a discount and premium situation.

Classification of Discounts and Premiums

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.

Accruing Interest on Bonds

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. Interest payable is reported as a current liability.

Extinguishment of Debt

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 to avoid misstatement of any resulting gain or loss on the extinguishment. 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) from extinguishment.

Notes Payable

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 bonds¾a discount or premium is recognized if the stated rate is different than the effective rate. Zero-interest-bearing notes have a present value that is less than the fair value, resulting in a discount on the note. The discount on long-term notes is amortized using the effective-interest method.

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 interest rate is unreasonable, or (c) the stated face amount of the debt instrument is materially different from the current cash sales price for the same or similar items or from the current fair value of the debt instrument. 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.

When an imputed interest rate is used for valuation purposes, it will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction. The object is to approximate the rate that would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions.

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 assessed by the lender 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.

Because of unusually high, unstable interest rates and a tight money supply, the traditional fixed-rate mortgage has been partially supplanted with alternative 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.

Fair Value Option

Companies may opt to record fair value in their accounts for most financial assets and liabilities including bonds and notes. The FASB believes the fair value measurement provides more relevant and understandable information than amortized cost. If companies choose this option, noncurrent liabilities are recorded at fair value, with unrealized holding gains or losses are reported as part of net income.

Off-Balance Sheet Financing

A significant issue in accounting today is the question of off-balance-sheet 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’s response to off-balance-sheet financing arrangements has been increased disclosure (note) requirements.

Presentation of Long-Term Debt

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. These footnote 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 assets ratio and the times interest earned.

Troubled Debt Restructurings

A troubled debt restructuring occurs when a creditor “for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.”

Settlement of Debt

Creditor. When noncash assets (real estate, receivables, or other assets) or the issuance of the debtor’s stock is used to settle a debt obligation in a troubled debt restructuring, the noncash assets or equity interest given should be accounted for at their respective fair values by the creditor. The creditor must determine the excess of the receivable over the fair value of those same assets or equity interests transferred (loss).

Debtor. The debtor is required to determine the excess of the carrying amount of the payable over the fair value of the assets or equity interests transferred (gain). The debtor recognizes a gain equal to the amount of the excess, and the creditor normally would charge the excess (loss) against Allowance for Doubtful Accounts. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair value of those assets differs from their carrying amount (book value).

Modification of Terms

When the terms of a loan agreement are modified in a troubled debt restructuring (e.g. reduction in interest rate), the creditor will incur a loss based upon cash flows discounted at the historical effective rate of the loan. Since the debtor’s gain will continue to be calculated based upon undiscounted amounts, the gain recorded by the debtor will not equal the loss recorded by the creditor.