Download CHAPTER 13:Financial Instruments: Long Term Debt

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CHAPTER 13:Financial Instruments: Long Term Debt
PAGE 777
1. Accounts Receivable and inventory are used ad security for operating lines of credit. Terms usually
allows the company to borrow up to 75% of the net realizable value of accounts receivable and 50%
of the book value of inventory.
2. Long-term loans are often an attractive means of financing for the borrower, as compared to
equity. These loans are appealing because:
• Long-term lenders are not shareholders, and do not acquire voting privileges over the
borrower, so issuance of debt causes no ownership dilution;
• Debt capital is obtained more easily than equity capital for many companies, especially
private companies;
• Interest expense, unlike dividends, is tax deductible; and
• A firm that earns a return on borrowed funds that exceeds the rate it must pay in interest
is using debt to its advantage and is said to be successfully levered (or leveraged).
3. The term, is the period of the lender’s commitment to extend the loan at the given interest rate
arrangement. The amortization period is the period of time given the interest rate and payments that
would see the debt repaid. Financial institutions typically grant such loans as asset based financing or
as commercial mortgages. Commercial mortgages are secured against land and buildings, and
involve regular blended payments (e.g., monthly or bimonthly). The amortization period of such loans
could be for as long as 25 years, but the term, or the lender’s commitment to extending the loan at
the given interest rate arrangement, is usually a shorter period such a 5 years.
4. A debt covenant is a restriction placed on a corporation’s activities as a condition of maintaining a
loan. Covenants are designed to protect a lender’s interest by limiting high-risk activities or preventing
Concept Review Solutions
© 2014 McGraw-Hill Ryerson, Ltd.
Intermediate Accounting, 6e, Volume 2
the borrower from falling into a high-risk position. Covenants may restrict dividend payments,
excessive leveraging, or transfers of control of the company.
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1. A premium on a bond payable arises when the stated (nominal) rate of interest on a bond exceeds
the prevailing market rate of interest. The present value of the bond will exceed the face value, and
investors will be willing to pay more than the face value (a premium) to acquire the bond. A bond
may offer an interest rate different from the market rate, as the bond terms are set in advance of the
actual issue date. For a bond to sell at par, the effective rate and the nominal rate must be the same.
For a bond to sell at a discount, the effective rate must exceed the nominal rate. For a bond to sell
at a premium, the nominal rate must exceed the effective rate.
2. The discount on a debt is recorded at issuance to reflect that the market rate of borrowing is higher
than is provided in the bond. As interest is paid at the lower face value of the bonds, the discount is
amortized and this is added to the paid interest to reflect the economic cost of borrowing which is
greater than the rate on the face of the debt.
3. Bonds are an investment for lenders, and may be sold before the maturity date. The bond will have
a fair value that reflects a revised present value. As market rates increase the fair value of a bond
would decrease. This is the value that one investor would pay another to purchase this bond. This fair
value is not recorded in the lender’s financial statements, but must be disclosed.
4. Accounting standards require that debt issuance cost be recorded and amortized on an effectiveinterest basis, as is any debt discount. The amount acts as an additional discount, or reduction of a
premium.
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© 2014 McGraw-Hill Ryerson, Ltd.
Intermediate Accounting, 6e, Volume 2
PAGE 790
1. The amount of long-term debt at the time the debt is issued is $1,100,000 ($1,000,000 x $1.10).
At the year-end there has been an exchange gain of $20,000 [$1,000,000 x ($1.10-$1.08)]. This
would reduce the long-term debt balance to $1,080,000.
2. The expense is $11,500 ($10,000 x $1.15) and the exchange gain is $500 ($10,000 x ($1.15$1.10)).
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1. Borrowing costs can be capitalized for qualifying assets, which are limited to non-financial assets
such as inventories, intangible assets, machinery, and office or manufacturing facilities. Borrowing
costs cannot be capitalized on financial assets, such as investments.
2. If a qualifying asset is purchased from general borrowings rather than with a specific loan, then the
calculations are more complex because it is harder to associate the borrowing with the acquisition. If
this is the case, the average borrowing rate is calculated on the total of general borrowings, and this
rate is applied to the specific expenditures made, for the time period involved.
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1. The change in the fair value of the bond liability is recorded when the liability is classified as fair
value through profit or loss. This results when the financial liability will be sold in the short term or
management wants to avoid an accounting mismatch.
2. A retractable bond is one that requires repayment at the holder’s (investor’s) discretion.
3. Gains and losses on debt retirement arise because the fair value at the retirement date has
changed due to changes in interest rates. Retirement prices reflect the fair value at the time of
retirement. When the debt is settled for a retirement amount that is different than its net book value,
a gain or loss will result and be recorded in the profit or loss of the period.
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© 2014 McGraw-Hill Ryerson, Ltd.
Intermediate Accounting, 6e, Volume 2
4. Defeasance is the situation whereby, under the terms of the bond indenture, a bond-issuing
company transfers cash into an irrevocable trusteed fund. The trustee invests the money in low-risk
securities that will match the term and interest flow of the bond payments. Such proceeds are used to
retire the corporate bonds at the maturity date. Under defeasance the company removes the liability
from the balance sheet. In-substance defeasance occurs when the company transfers the risk but
does not have the agreement of the investor set out in the bond indenture. In this case, the
investment and the debt are shown separately.
Concept Review Solutions
© 2014 McGraw-Hill Ryerson, Ltd.
Intermediate Accounting, 6e, Volume 2