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Chapter 14 Bonds Long-Term Liabilities Annual reports: Coca-Cola 1 Bonds 2 Long-Term Liabilities § Chapter 14 § Bonds payable § Long-term notes payable § Mortgages payable § Other chapters § Pension liabilities § Lease liabilities § Tax liabilities 3 Learning Objectives 4 Learning Objective 1 § Describe formal procedures associated with issuing long-term debt 1. Describe formal procedures issuing long-term debt 2. Identify various types of bond issues 3. Valuation for bonds at date of issuance 4. Amortization of bond discount and premium 5. Extinguishment of non-current liabilities 6. Accounting for long-term notes payable 7. Accounting for fair value option 8. Explain reporting of off-balance-sheet financing 9. Indicate how to present and analyze long-term debt 10. Appendix: Troubled debt restructuring 5 6 1 Long-Term Liabilities Issuing Bonds § Probable sacrifice of future economic benefits § Arising from present obligations § Payable in more than one year or operating cycle, whichever is longer § Bond contract = Bond indenture § Promise to pay § Face value at maturity (single amount) § Periodic interest (annuity) § Typically a $1,000 face value § Interest usually paid semi-annually 7 8 9 10 11 12 CASH FOR SMALL DEBT Small debt borrowed from single source 2 $1.6 Billion Bank Loan? No! § Bank does not have $1,600,000,000 § Diversify risk § Many small loans § A few small defaults § Not one big default 13 NEED $1.6 BILLION LOAN 14 CASH FOR LARGE DEBT § Tesla needs cash to build factory § Large debt broken into small pieces Large debts financed by selling bonds to banks, insurance companies, pension funds, public Bonds Cash $1,600,000,000 Sell 1,600,000 bonds at $1,000 each 15 16 17 18 3 Learning Objective 2 § Identify various types of bond issues 19 20 Types of Bonds Secured Unsecured (debenture) Term Serial Callable Convertible Commodity-Backed Deep-Discount Registered Income Bearer (Coupon) Revenue Bond Listings Zero-coupon Company Name Price as a % of par Interest rate based on price 21 Learning Objective 3, 4 Interest rate paid as a % of par value 22 Issuance, Marketing of Bonds § Describe accounting valuation for bonds at date of issuance § Apply methods of bond discount and premium amortization § Issuing company must § Arrange for underwriters § Obtain SEC approval of bond issue, undergo audits, and issue a prospectus 23 24 4 Selling Price Determined By Two Interest Rates § Supply of bonds § Demand of buyers § Relative risk § Market conditions § State of economy § Stated, coupon, nominal, contract § Rate written in bond contract § Bond issuer sets coupon rate § Stated as percentage of face value (par) § Market rate, effective yield § Rate that provides acceptable return to bond buyers, considering risk § Rate of interest earned by bondholders 25 Par, Premium, Discount 26 Book Value (Carrying Amount) Bond stated rate, 8% Market Interest Bonds Sold At 6% Premium 8% Par Value 10% Discount − + Bonds issued at a discount Face value Remaining discount Book value (Carrying amount) Bonds issued at a premium Face value Remaining premium Book value (Carrying amount) 27 28 Interest Calculations Amortization Amount Effective Interest = Bond book value × market rate × time Effective interest expense (Market rate) Annuity Payment = Face value × stated rate × time Effective Interest = Book value × market rate × time Changes Changes Same Same − Annuity payment (Interest paid) Annuity Payment = Face value × stated rate × time Same Same Same Amortization Amount Effective interest expense Annuity payment Amortization amount Same 29 30 5 BONDS BONDS § Notes payable § Issued to multiple lenders § Sold in units of $1,000 § Bond buyers loan money to earn interest on excess cash § Issuing company to pay bondholder § Interest semi-annually § Face value on maturity date § Face value § Par value § Maturity value § Amount bond holder receives on maturity date (future value) 31 32 Two Interest Rates Face value Issue date Coupon rate Maturity date Interest rate Note issued at Stated rate = Market rate Face value (par) Stated rate < Market rate Discount (less than par) Stated rate > Market rate Premium (more than par) Payment dates 33 ISSUED AT PAR 34 ISSUED AT PAR § A $1,000 bond issued at par § Market rate = coupon rate § Bond sells for face value § Quoted at 100 § Sell for 100% of face value § Bought or sold for $1,000 § Interest only loan § Interest paid in full at end of each period § Face value paid in full on maturity date 35 36 6 Bond Contract ISSUED AT PAR Face value $50,000 Life 3 years Stated interest rate Bond Contract Face value $50,000 Life 3 years Stated interest rate Semi-Annually Market Rate 10% Compounding (interest paid) 10% Compounding (interest paid) Semi-Annually Effective interest rate (market rate) 10% Issue price (market price) $50,000 Market Rate Effective interest rate (market rate) 10% Issue price (market price) $50,000 Description Cash Debit 50,000 Bonds Payable Credit 50,000 37 CALCULATE ANNUITY PAYMENT AT MATURITY § Coupon rate used to compute annuity (periodic interest payments) § On maturity date § Make last interest payment § Pay face value in full Coupon Payment Calculation Payment = Face Value Payment = $50,000 Payment = $2,500 Description Interest Expense × Coupon Rate × Time × 10% × 38 Description Interest Expense 1/2 Debit 2,500 Cash Debit 2,500 Cash 2,500 Beginning Balance Effective Interest Annuity Payment 1 50,000 2,500 2,500 50,000 2 50,000 2,500 2,500 50,000 3 50,000 2,500 2,500 50,000 4 50,000 2,500 2,500 50,000 5 50,000 2,500 2,500 50,000 6 50,000 2,500 2,500 50,000 15,000 15,000 0 Description Bonds Payable Credit 39 Cash Credit 2,500 Debit 50,000 Credit 50,000 40 Ending Balance 50,000 Effective Interest = Beginning balance × market rate × time Annuity Payment = Face value × stated rate × time 41 42 7 TWO INTEREST RATES TWO INTEREST RATES § Rate printed on bond called § Coupon interest rate § Coupon rate § Stated rate § Contract rate § Determines semi-annual payment § Market interest rate § Determines bond market price (PV) § Effective interest expense § Market interest rate called § Effective-rate § Yield-to-maturity 43 44 45 46 47 48 8 BOND MARKET MARKET RATE § Many buyers § Many sellers § Almost perfect information because § Compare to bonds from similar corps § Due date § Industry § Risk of default (rating) § Bonds are rated § Information available over internet § Highly efficient § Fairly priced 49 BOND RATING 50 BOND RATING § Independent opinion of risk of default 51 52 53 54 BOND RATING Ç Investment grade È Ç Junk bonds È S&P AAA AA A BBB BB B C D Moody’s Aaa Aa A Baa Ba B C D 9 55 ISSUED AT DISCOUNT § A $1,000 bond issued at a discount § Market rate > coupon rate § Bond sells for less than face value § For example § Quoted at 88 3/8 § Sells for 88 3/8% of face value § Bought or sold for $ 883.75 60 10 Two Interest Rates Interest Calculations § Coupon interest rate Effective interest expense (Market rate) § Determines semi-annual payment Effective Interest = Book value × market rate × time § Market interest rate § Determines bond market price (PV) § Effective interest expense Changes Changes Same Same Annuity payment (Interest paid) Annuity Payment = Face value × stated rate × time Same Same Same Same 10:61 62 Two interest rates Bond Issued At Discount Interest rate Note issued at Stated rate = Market rate Face value (par) Stated rate < Market rate Discount (less than par) Stated rate > Market rate Premium (more than par) Bond Contract Face value $5,000 Life 3 years Stated interest rate 7% Compounding (interest paid) Semi-Annually Market Rate Effective interest rate Issue price Discount 63 Bond Issued at Discount Face value $5,000 Stated rate 7% Payment = Face Value $175 = Term Rate per period PV PV 0 5% $382 64 5% Number of periods 6 Future Value × PV$1 Factor = Present Value 7% × $5,000 × 0.746 = $3,730 1/2 Annuity × PV$1 Annuity Factor = Present Value Rate and Periods (Semi-annual Coupon Payments) Rate per period (market discount) 10% × Coupon Rate × Time × 10% $4,618 Rate and Periods (Semi-annual Coupon Payments) 3 years Market rate $5,000 (market rate) (market price) Number of periods Present value of future value discounted at market rate of 5% $175 × 5.076 = $888 6 5,000 3,730 Present value of annuity discounted at market rate of 5% 888 175 175 175 175 175 175 1 2 3 4 5 6 65 Present value of future value discounted at market rate of 5% 5,000 Present value of annuity discounted at market rate of 5% 4,618 175 175 175 175 175 175 0 1 2 3 4 5 6 66 11 Calculation of Present Value of Bond (Issue Price) Present value of future value + Present value of annuity 888 Face value of bond 888 Present value of bond (issue price) 3,730 Calculation of Discount on Bond Payable $3,730 $4,618 Present value of future value discounted at market rate of 5% 5,000 3,730 888 4,618 175 175 175 175 175 175 0 1 2 3 4 5 6 67 Bond Price Stated as Percentage of Face Value = Bond price = Bond price = Market value of bond Face value of bond 4,618 5,000 4,618 Discount on bond payable Present value of annuity discounted at market rate of 5% Bond price $5,000 − Present value of bond (issue price) $ 382 Present value of future value discounted at market rate of 5% 5,000 Present value of annuity discounted at market rate of 5% 4,618 175 175 175 175 175 175 0 1 2 3 4 5 6 Given Bond Price Calculate Market Value Ï 100 Market value = Ï 100 Market value = Market value = 92.36 Face value Ï Price 100 5,000 Ï 92.36 100 4,618 69 Journal Entry to Issue Bond Calculation of Discount on Bond Payable Face value of bond $5,000 − Present value of bond (issue price) 4,618 Discount on bond payable Description Cash $ 382 Debit 4,618 68 Credit 70 Discount on Bonds Payable § Additional interest expense over life of bond to increase effective interest from stated rate to market rate Bonds Payable 5,000 Discount on Bonds Pay 382 Discount on Bonds Payable 382 Bonds Payable 5,000 Issued $5,000 bond at discount; stated rate 7%, market rate 10% Discount on Bonds Payable is a contra-liability account 72 12 Calculation of Discount on Bond Payable Note Issued at Discount Face value of bond 4,618 Discount on bond payable Effective Interest Annuity Payment Balance Sheet [Date Bonds Issued] $ 5,000 Less Discount on Bonds Payable 382 Net Bonds Payable Discount Discount Amortized Remaining Ending Balance 1 4,618 231 175 56 382 4,618 326 2 4,674 234 175 4,674 59 267 3 4,733 237 4,733 175 62 205 4 4,795 4,795 240 175 65 140 5 4,860 4,860 243 175 68 72 6 4,928 4,928 246 175 72 0 5,000 0 $ 382 Bonds Payable $ 382 Beginning Balance $5,000 − Present value of bond (issue price) 4,618 Discount on bond payable Calculation of Discount on Bond Payable Face value of bond $5,000 − Present value of bond (issue price) $ 4,618 73 74 Effective Interest = Beginning Balance × Market Rate × Time Annuity = Face Value × Coupon Rate × Time 231 = 4,618 × 10% × 1/2 175 = 5,000 × 7% × 1/2 Beginning Balance Effective Interest Annuity Payment Discount Discount Amortized Remaining Ending Balance Beginning Balance Effective Interest Annuity Payment 1 4,618 231 175 56 382 4,618 0 326 4,674 1 4,618 231 175 56 2 4,674 234 175 59 267 4,733 2 4,674 234 175 3 4,733 237 175 62 205 4,795 3 4,733 237 4 4,795 240 175 65 140 4,860 4 4,795 5 4,860 243 175 68 72 4,928 5 6 4,928 246 175 72 0 5,000 6 0 Discount Discount Amortized Remaining Ending Balance 382 4,618 326 4,674 59 267 4,733 175 62 205 4,795 240 175 65 140 4,860 4,860 243 175 68 72 4,928 4,928 246 175 72 0 5,000 75 76 Discount Amortized = Effective Interest − Annuity Payment Discount Remaining = Prior Discount Remaining − Discount Amortized 56 = 231 − 175 326 = 382 − 56 Beginning Balance Effective Interest Annuity Payment Discount Discount Amortized Remaining Ending Balance Beginning Balance Effective Interest Annuity Payment 1 4,618 231 175 56 382 4,618 0 326 4,674 1 4,618 231 175 56 2 4,674 234 175 59 267 4,733 2 4,674 234 175 3 4,733 237 175 62 205 4,795 3 4,733 237 4 5 4,795 4,860 240 243 175 175 65 68 140 72 4,860 4,928 4 5 4,795 4,860 6 4,928 246 175 72 0 5,000 6 4,928 0 77 Discount Discount Amortized Remaining Ending Balance 382 4,618 326 4,674 59 267 4,733 175 62 205 4,795 240 243 175 175 65 68 140 72 4,860 4,928 246 175 72 0 5,000 78 13 Ending Balance = Face Value − Discount Remaining 4,674 = 5,000 − 326 Beginning Balance Effective Interest Annuity Payment Beginning Balance Effective Interest Annuity Payment Discount Discount Amortized Remaining Ending Balance 1 4,618 231 175 56 382 4,618 326 2 4,674 234 175 4,674 59 267 3 4,733 237 4,733 175 62 205 4,795 0 Discount Discount Amortized Remaining Ending Balance 382 4,618 4 4,795 240 175 65 140 4,860 0 1 4,618 231 175 56 326 4,674 5 4,860 243 175 68 72 4,928 2 4,674 234 175 59 267 4,733 6 4,928 246 175 72 0 5,000 3 4,733 237 175 62 205 4,795 1,432 1,050 382 4 4,795 240 175 65 140 4,860 5 4,860 243 175 68 72 4,928 6 4,928 246 175 72 0 5,000 Discount [382] is additional interest expense paid to raise coupon payments [1,050] to market interest [1,432] 79 80 First Coupon Payment Beginning Balance Effective Interest Annuity Payment 4,618 231 175 Discount Discount Amortized Remaining Ending Balance 382 4,618 0 326 4,674 267 4,733 Debit Credit 62 205 4,795 231 65 140 4,860 56 68 72 4,928 175 72 0 5,000 0 1 2 4,674 234 175 Description 3 4,733 237 175 Interest Expense 4 4,795 240 175 Discount on Bonds Payable 5 4,860 243 175 Cash 6 4,928 246 175 First coupon payment on bonds payable Second Coupon Payment 56 59 Beginning Balance Effective Interest Annuity Payment Discount Discount Amortized Remaining Ending Balance 1 4,618 231 175 56 382 4,618 326 2 4,674 234 175 59 4,674 267 4,733 3Description 4,733 237 175 4Interest 4,795 240 175 Expense 5 Discount 4,860 on Bonds 243 Payable 175 6 4,928 246 175 Cash Second coupon payment on bonds payable 62 Debit 205 Credit 4,795 65 140 4,860 234 68 72 4,928 59 72 0 5,000 175 81 Balance Sheet: End of Second Period Beginning Balance Effective Interest Annuity Payment 1 4,618 231 175 56 2 4,674 234 175 3 4 4,733 4,795 237 240 175 175 5 4,860 243 6 4,928 246 Balance Sheet: End of Second Period Discount Discount Amortized Remaining Ending Balance 382 4,618 326 4,674 59 267 4,733 62 65 205 140 4,795 4,860 175 68 72 4,928 175 72 0 5,000 0 82 83 Bonds Payable Discount on Bonds Pay 5,000 382 56 59 5,000 267 Balance Sheet [End of Second Period] Bonds Payable $ 5,000 Less Discount on Bonds Payable Net Bonds Payable 267 $ 4,733 84 14 Two interest rates Bond Issued At Premium Interest rate Note issued at Stated rate = Market rate Face value (par) Stated rate < Market rate Discount (less than par) Stated rate > Market rate Premium (more than par) § A $1,000 bond issued at a premium § Market rate < coupon rate § Bond sells for more than face value § For example § Quoted at 101½ § Sells for 101½% of face value § Bought or sold for $ 1,015 85 86 Bond Issued at Premium Bond Issued At Premium Bond Contract Face value $6,000 Life 3 years Stated interest rate Premium 12% Payment = Face Value = Term 3 years Market rate 8% × Coupon Rate × Time $6,000 × 12% × 1/2 Rate and Periods (Semi-annual Coupon Payments) Rate per period 4% Number of periods 6 Semi-Annually Present value of future value discounted at market rate of 4% PV Market Rate Effective interest rate Issue price $6,000 Stated rate $360 12% Compounding (interest paid) Face value (market rate) (market price) 8% $6,627 (market discount) $627 PV 87 6,000 Present value of annuity discounted at market rate of 4% 0 360 360 360 360 360 360 1 2 3 4 5 6 88 Rate and Periods (Semi-annual Coupon Payments) Rate per period 4% Number of periods 6 Calculation of Present Value of Bond (Issue Price) Present value of future value Future Value × PV$1 Factor = Present Value $4,740 + Present value of annuity $6,000 × 0.790 = $4,740 1,887 Present value of bond (issue price) $6,627 Annuity × PV$1 Annuity Factor = Present Value $360 × 5.242 = $1,887 4,740 1,887 Present value of future value discounted at market rate of 4% 6,000 4,740 Present value of annuity discounted at market rate of 4% 1,887 6,627 360 360 360 360 360 360 0 1 2 3 4 5 6 89 Present value of future value discounted at market rate of 4% 6,000 Present value of annuity discounted at market rate of 4% 6,627 360 360 360 360 360 360 0 1 2 3 4 5 6 90 15 Journal Entry to Issue Bond Calculation of Premium on Bond Payable Present value of bond (issue price) $6,627 − Face value of bond Calculation of Premium on Bond Payable 6,000 Premium on bond payable Present value of bond (issue price) $ 627 $6,627 − Face value of bond 6,000 Premium on bond payable 4,740 1,887 Present value of future value discounted at market rate of 4% Description Cash 6,000 360 360 360 360 360 360 0 1 2 3 4 5 6 Debit 6,627 627 Bonds Payable 6,000 Issued $5,000 bond at premium; stated rate 12%, market rate 8% 91 Premium on Bonds Payable Note Issued at Premium § Overpayment of coupon payments collected in advance to lower effective interest from stated rate to market rate Calculation of Premium on Bond Payable Present value of bond (issue price) $ 6,627 − Face value of bond 6,000 Premium on bond payable Bonds Payable Credit Premium on Bonds Payable Present value of annuity discounted at market rate of 4% 6,627 $ 627 $ 627 Premium on Bonds Pay 6,000 627 Balance Sheet [Date Bonds Issued] Bonds Payable $ 6,000 Add Premium on Bonds Payable Premium on Bonds Payable is an adjunct account $ 6,627 − Face value of bond 6,000 Premium on bond payable $ Beginning Balance Effective Interest Annuity Payment 1 6,627 265 360 95 2 6,532 261 360 3 6,433 257 4 5 6,330 6,223 6 6,112 $ 6,627 93 Calculation of Premium on Bond Payable Present value of bond (issue price) 627 Net Bonds Payable 94 Effective Interest = Beginning Balance × Market Rate × Time 265 = 6,627 × 8% × 1/2 627 Premium Premium Amortized Remaining Ending Balance Beginning Balance Effective Interest Annuity Payment 627 6,627 0 532 6,532 1 6,627 265 360 95 99 433 6,433 2 6,532 261 360 360 103 330 6,330 3 6,433 257 253 249 360 360 107 111 223 112 6,223 6,112 4 5 6,330 6,223 244 360 112 0 6,000 6 6,112 0 95 Premium Premium Amortized Remaining Ending Balance 627 6,627 532 6,532 99 433 6,433 360 103 330 6,330 253 249 360 360 107 111 223 112 6,223 6,112 244 360 112 0 6,000 96 16 Annuity = Face Value × Coupon Rate × Time Premium Amortized = Annuity Payment − Effective Interest 360 = 6,000 × 12% × 1/2 95 = 360 − 265 Beginning Balance Effective Interest Annuity Payment Premium Premium Amortized Remaining Ending Balance Beginning Balance Effective Interest Annuity Payment 1 6,627 265 360 95 627 6,627 0 532 6,532 1 6,627 265 360 95 2 6,532 261 360 99 433 6,433 2 6,532 261 360 3 6,433 257 360 103 330 6,330 3 6,433 257 4 6,330 253 360 107 223 6,223 4 6,330 5 6,223 249 360 111 112 6,112 5 6 6,112 244 360 112 0 6,000 6 0 Premium Premium Amortized Remaining Ending Balance 627 6,627 532 6,532 99 433 6,433 360 103 330 6,330 253 360 107 223 6,223 6,223 249 360 111 112 6,112 6,112 244 360 112 0 6,000 97 98 Premium& Remaining = Prior Premium Remaining − Premium Amortized Ending Balance = Face Value + Premium Remaining 532 = 627 − 95 6,532 = 6,000 + 532 Beginning Balance Effective Interest Annuity Payment Premium Premium Amortized Remaining Ending Balance Beginning Balance Effective Interest Annuity Payment 1 6,627 265 360 95 627 6,627 0 532 6,532 1 6,627 265 360 95 2 6,532 261 360 99 433 6,433 2 6,532 261 360 3 6,433 257 360 103 330 6,330 3 6,433 257 4 6,330 253 360 107 223 6,223 4 6,330 5 6,223 249 360 111 112 6,112 5 6 6,112 244 360 112 0 6,000 6 0 Premium Premium Amortized Remaining Ending Balance 627 6,627 532 6,532 99 433 6,433 360 103 330 6,330 253 360 107 223 6,223 6,223 249 360 111 112 6,112 6,112 244 360 112 0 6,000 99 Beginning Balance Effective Interest Annuity Payment 1 6,627 265 360 2 6,532 261 3 6,433 257 4 6,330 5 6,223 6 6,112 Premium Premium Amortized Remaining Ending Balance 0 627 6,627 95 532 6,532 360 99 433 6,433 360 103 330 6,330 253 360 107 223 6,223 249 360 111 112 6,112 0 6,000 244 360 112 1,533 2,160 627 Premium [627] is annuity overpayment collected in advance to lower coupon payments [2,160] to market interest [1,533] 101 100 First Coupon Payment Beginning Balance Effective Interest Annuity Payment 6,627 265 360 Premium Premium Amortized Remaining Ending Balance 627 6,627 532 6,532 0 1 2 6,532 261 360 Description 3 6,433 257 360 Interest Expense 4 6,330 253 360 Premium on Bonds Payable 5 6,223 249 360 Cash 6 6,112 244 360 First coupon payment on bonds payable 95 99 433 6,433 Debit Credit 103 330 6,330 265 107 223 6,223 95 111 112 6,112 360 112 0 6,000 102 17 Balance Sheet: End of Second Period Second Coupon Payment Beginning Balance Effective Interest Annuity Payment Premium Premium Amortized Remaining Ending Balance Beginning Balance Effective Interest Annuity Payment 1 6,627 265 360 95 627 6,627 0 532 6,532 1 6,627 265 360 95 2 6,532 261 360 99 433 6,433 2 6,532 261 360 3Description 6,433 257 4Interest 6,330 Expense 253 360 360 103 Debit 330 Credit 6,330 107 223 6,223 261 111 6,112 99112 3 4 6,433 6,330 257 253 360 360 5 6,223 249 112 6 6,112 244 0 5Premium 6,223 249 on Bonds Payable 360 6 Cash 6,112 244 360 0 6,000 360 Premium Premium Amortized Remaining Ending Balance 627 6,627 532 6,532 99 433 6,433 103 107 330 223 6,330 6,223 360 111 112 6,112 360 112 0 6,000 Second coupon payment on bonds payable 103 Balance Sheet: End of Second Period Bonds Payable 104 Book Value (Carrying Amount) Premium on Bonds Pay 6,000 95 Bonds issued at a discount 627 99 6,000 − 433 Balance Sheet [End of Second Period] Bonds Payable Add Premium on Bonds Payable $ 6,000 433 Net Bonds Payable $ 6,433 + Face value Remaining discount Book value (Carrying amount) Bonds issued at a premium Face value Remaining premium Book value (Carrying amount) 105 106 Bonds Issued Between Interest Dates WileyPLUS § Brief exercises 1 - 8 § Bond buyer pays seller interest accrued from last interest payment date to date of purchase § On next semiannual interest payment date, bond investors will receive full annuity payment 107 108 18 Bonds Issued Between Interest Dates Bond Issue Costs § Debit asset account Interest payment dates § Legal fees § Accounting fees § Commissions Interest accrued § Amortize over life of debt § Effective interest preferred § Straight-line commonly used (immaterial) Bond purchased 109 Bond Issue Costs WileyPLUS § Brief exercises 10 Description Debit Credit Cash 20,550 Unamortized bond issue costs (asset) 240 Premium on bonds payable 790 Bonds payable 20,000 Issued bonds with face value $20,000 for $20,790. Issuing costs, $240 Description Debit Bond issue expense 24 Unamortized bond issue costs End of year AJE: Amortize issue costs over 10 years 110 Credit 24 111 Learning Objective 5 112 Extinguishment of Debt § Extinguishment of debt § If paid on maturity date § Premium / discount fully amortized § Issuing costs fully amortized § Make last interest payment § Pay face value in full § Face value = Fair value § No gain or loss § If debt retired early gain or loss possible 113 114 19 − Carrying amount Reacquisition price Gain (loss) on extinguishment of debt + − − Face value Unamortized premium Unamortized discount Unamortized issuance costs Carrying amount (book value) + + Face value Call premium (callable at 103) Reacquisition expenses Reacquisition price 115 WileyPLUS 116 Learning Objective 6 § Brief exercise 11 § Explain accounting for long-term notes payable 117 Long-Term Notes Payable 118 Stated Rate = Market Rate Description Debit Credit Cash 10,000 Note payable 10,000 $10,000, 10%, 3 year note issued at par (market rate 10% = stated rate) § Accounting similar to bonds § Note valued at present value of future interest and principal cash flows § Company amortizes discount or premium over life of note 119 Description Debit Interest expense 1,000 Cash Annual interest payment, $10,000 × 10% × 1 = $1,000 Credit Description Debit Note payable 10,000 Cash Face value of note payable paid in full on maturity date Credit 1,000 10,000 120 20 Stated Rate ≠ Market Rate Zero-Interest-Bearing Notes § Stated interest ≠ Effective interest § Note face value ≠ Present value § Evaluate exchange to properly value assets, liabilities, and interest § Record difference between § Face amount (future cash outflow, FV) § Cash received (present cash inflow, PV) § Discount § Discount = Face amount − Cash received § Discount is future interest expense § Amortize discount using effective interest method over life of note 121 122 Zero-Interest-Bearing Notes Zero-Interest-Bearing Notes § Implicit interest rate is rate that equates cash received (present value) with amount paid in future (future value) PV PV 0 PV 123 0 Present value of future value discounted at market rate of 4% 6,000 Present value of annuity discounted at market rate of 4% 360 360 360 360 360 360 1 2 3 4 5 6 Present value of future value discounted at market rate of 4% 1 2 3 4 5 124 6,000 6 124 Note Exchanged For Noncash Consideration Interest-Bearing Notes § Stated interest rate ≠ Market rate § Stated rate unreasonable § Use market rate to imputed interest § Discount or premium recognized and amortized over life of note § When note exchanged for noncash consideration (bargained transaction) stated rate presumed fair unless § No interest rate is stated § Stated interest rate is unreasonable § Stated face amount of debt instrument is materially different from § Current cash sales price for similar items § Current fair value of debt instrument 125 126 21 Imputed Rate Imputed Interest Calculation § Imputed rate = Market rate § Rate debtor would receive from independent lender § Imputed interest rate to note 1. Create a timeline showing all future cash flows 1. Face value of note paid at maturity date 2. Interest payments using stated rate 2. Discount future cash flows using imputed interest rate 3. Value asset at discounted amount 4. Use effective interest calculations 127 128 Note With Unreasonable Stated Interest Rate Face value $6,000 Stated rate 12% Payment = Face Value $360 = Term Note With Unreasonable Stated Interest Rate 3 years Face value $6,000 8% Stated rate 12% Payment = Face Value Market rate × Coupon Rate × Time $6,000 × 12% × 1/2 $360 Rate and Periods (Semi-annual Coupon Payments) Rate per period PV PV 0 4% Number of periods 3 years Market rate 8% × Coupon Rate × Time $6,000 × 12% × 1/2 Rate and Periods (Semi-annual Coupon Payments) 6 Present value of future value discounted at market rate of 4% = Term Rate per period 6,000 4,740 Present value of annuity discounted at market rate of 4% 1,887 360 360 360 360 360 360 1 2 3 4 5 6 129 Notes Issued for Property, Goods, or Services 4% Number of periods Present value of future value discounted at market rate of 4% 6 6,000 Present value of annuity discounted at market rate of 4% 6,627 360 360 360 360 360 360 0 1 2 3 4 5 6 130 WileyPLUS § If fair value of property, goods, services exchanged cannot be determined and note has no FMV, estimate interest rate § Brief exercise 12 - 15 § Prevailing rates for similar instruments § Consider factors such as restrictive covenants, collateral, payment schedule, and existing prime interest rate 131 132 22 Mortgage Notes Payable Learning Objective 7 § Common method of financing property, plant, equipment § Title to asset pledged as security § Points raise effective interest rate § If paid on installment basis, current installment classified as current liability § Describe accounting for fair value option 133 134 Fair Value Option Fair Value Measurement § Companies have option to record most financial assets and liabilities, including bonds and notes payable, at fair value § FASB believes valuing financial instruments at fair value provides more relevant, understandable information than amortized cost § Non-current liabilities are recorded at fair value, with unrealized holding gains or losses reported as part of net income Description Debit Credit Bond payable 20,000 Unrealized holding gain (loss) 20,000 Fair value of bonds $20,000 less than book value, write down bonds § Amortized cost = Face value + Accrued int 135 WileyPLUS 136 Learning Objective 8 § Brief exercise 16 § Explain reporting of off-balance-sheet financing arrangements 137 138 23 Off-Balance-Sheet Financing Learning Objective 9 § Attempt to borrow monies in manner to avoid recording a liability § Indicate how to present and analyze long-term debt § Non-Consolidated Subsidiary § Special Purpose Entity (SPE) § Operating Leases § FASB response: increased disclosure 139 Note Disclosures 140 Note Disclosures § Nature of liabilities § Maturity dates § Interest rates § Call provisions § Conversion privileges § Restrictions imposed by creditors § Assets designated, pledged as security § Fair value of debt § Future payments for sinking fund requirements § Maturity amounts of long-term debt during each of next five years 141 Ratios Debt Ratio (Debt to Total Assets) = Times-InterestEarned Ratio = 142 WileyPLUS § Brief exercise 9 Total Liabilities Total Assets Income before taxes, interest Interest Expense 143 144 24 Learning Objective 10 Troubled-Debt Restructurings § Describe accounting for a debt restructuring (Appendix 14A) § Creditor grants concession to debtor that creditor would not otherwise make § Two types of troubled-debt restructuring 1. Settlement at less than carrying amount 2. Continuation with modification of terms Loan Origination Loan Impairment Modification of Terms Possible Bankruptcy 145 Settlement of Debt: Two Options 146 Two Gain (Loss) Calculations § Transfer of noncash assets § Settlement creates two calculations § Receivables, inventory, property #1: Compare BV Debt to FV Assets (Equity) Given § Issuance of stock by debtor Carrying amount of debt (book value) − Fair value of assets (or equity) given Creditor records incoming assets (or equity) at fair value Debtor’s Gain (Creditor’s Loss) #2: Assets (Equity) Given: Compare FV to BV Fair value of assets (or equity) given − Book value of assets (or equity) given 147 Lender Accepts Land in in Debt Settlement Book value of debt $20,000 Fair value of land $16,000 Land book value (borrower) $21,000 Lender Accepts Land in in Debt Settlement $16,000 Debtor’s Gain (Creditor’s Loss) $ 4,000 $20,000 Fair value of land $16,000 Description Debit Credit Land 16,000 Allowance for doubtful accounts Plug 4,000 Note receivable 20,000 Lenders books: Lender accepts land in full settlement of $20,000 loan #2: Assets (Equity) Given: Compare FV to BV Fair value of assets (or equity) given $16,000 Debtor’s Gain (or Loss) Book value of debt $20,000 − Fair value of assets (or equity) given − Book value of assets (or equity) given 148 Lender: Debt Settlement #1 #1: Compare BV Debt to FV Assets (Equity) Given Carrying amount of debt (book value) Debtor’s Gain (or Loss) $21,000 ($ 5,000) 149 150 25 Lender Accepts Common Stock in Debt Settlement Borrower: Debt Settlement #1 Lender Accepts Land in in Debt Settlement Book value of debt $20,000 Fair value of land $16,000 Land book value (borrower) $21,000 Description Debit Credit Note payable 20,000 Loss on disposal of land 5,000 Land 21,000 Gain on debt restructuring 4,000 Plug Borrowers books: Lender accepts land in full settlement of $20,000 loan Book value of debt $20,000 Fair value of common stock $16,000 Stock book value (borrower) None #1: Compare BV Debt to FV Assets (Equity) Given Carrying amount of debt (book value) $20,000 − Fair value of assets (or equity) given $16,000 Debtor’s Gain (Creditor’s Loss) $ 4,000 #2: Assets (Equity) Given: Compare FV to BV Fair value of assets (or equity) given − Book value of assets (or equity) given 151 Lender: Debt Settlement #2 Debtor’s Gain (or Loss) $16,000 None None 152 Borrower: Debt Settlement #2 Lender Accepts Common Stock in Debt Settlement Lender Accepts Common Stock in Debt Settlement Book value of debt $20,000 Book value of debt $20,000 Fair value of common stock $16,000 Fair value of common stock $16,000 Description Debit Credit Equity investments (common stock) 16,000 Allowance for doubtful accounts 4,000 Note receivable 20,000 Lenders books: Lender accepts stock in full settlement of $20,000 loan 153 Types of Modifications Shares issued 320 Par value per share $10 Description Debit Credit Note payable 20,000 Common stock (320 × $10) 3,200 Additional paid-in capital 12,800 Plug Gain on debt restructuring 4,000 Borrowers books: Lender accepts land in full settlement of $20,000 loan 154 Modification of Terms § Extension of maturity date § Reduction of face amount of debt § Reduction of stated interest rate § Reduction (or deferral) of interest due § All of the above § Creditor’s loss ≠ Debtor’s gain Creditor’s Loss Based upon discounted cash flows Debtor’s Gain Based upon undiscounted cash flows Lender takes a haircut 155 156 26 Modification of Terms Example 1: Debtor, No Gain § Debtor does not record gain when total future cash flows exceed prerestructuring carrying amount of debt § Debtor records gain when prerestructuring carrying amount of debt exceeds future cash flows Original Restructuring Due date Dec 31, 2011 Dec 31, 2015 Principal $10,500,000 $9,000,000 12% 8% Interest rate Date of restructuring Dec 31, 2011 Future cash flows > Pre-restructuring carrying amount $9,000,000 + ($9,000,000 × 8% × 4) > $10,500,000 $11,880,000 > $10,500,000 157 Debtor makes no entry on restructuring 158 Example 1: Debtor, No Gain § Debtor computes effective-interest rate § Use PV of new future cash flows and carrying amount of pre-structuring debt Description Debit Credit Note payable 356,056 Interest expense 363,944 Cash 720,000 Debtor JE: 12/31/2012, First interest payment after restructuring 159 Example 1: Creditor, Loss 160 Example 1: Creditor, Loss § Creditor calculates loss based on future cash flows discounted at original (historical) effective interest rate § Recognize full loss in period of restructuring § Record periodic interest revenue using original rate 161 Description Debit Credit Bad debt expense 2,593,428 Allowance for doubtful accounts 2,593,428 162 Creditor JE: 12/31/2011, Record loss on date of restructuring 27 Example 1: Creditor, Loss Example 2: Debtor, Gain § Debtor records gain when prerestructuring carrying amount of debt exceeds future cash flows Description Debit Credit Cash 720,000 Allowance for doubtful accounts 228,789 Interest revenue 948,789 Creditor JE: 12/31/2012, First interest payment after restructuring 163 Example 2: Debtor, Gain Example 2: Debtor, Gain Future cash flows < Pre-restructuring carrying amount $7,000,000 + ($7,000,000 × 8% × 4) < $10,500,000 $9,240,000 < $10,500,000 On Dec 31, 2011 § Principal reduced § $10,500,000 to $7,000,000 Calculation of Debtor Gain Pre-restructuring carrying amount § Maturity date extended § Dec 31, 2011 to Dec 31, 2015 § Interest rate reduced § From 12% to 8% Future cash flows < Pre-restructuring carrying amount $7,000,000 + ($7,000,000 × 8% × 4) > $10,500,000 164 165 Example 2: Debtor, Gain $10,500,000 Future cash flows $9,240,000 Gain on debt restructuring $1,260,000 Description Debit Credit Note payable 1,260,000 Gain on debt restructuring 1,260,000 166 Debtor JE: 12/31/201, Write-down of debt principal after restructuring Example 2: Creditor, Loss § Principal balance on loan is equal to actual (undiscounted) future cash flows § Imputed interest rate = 0% § All period payments principal only § No interest expense Description Debit Credit Note payable 560,000 Cash 560,000 167 Debtor JE: 12/31/2012, First interest payment after restructuring Description Debit Credit Bad debt expense 4,350,444 Allowance for doubtful accounts 4,350,444 Creditor JE: 12/31/2011, Record loss on date of restructuring 168 28 Description Debit Credit Cash 560,000 Allowance for doubtful accounts 177,947 Interest revenue 737,947 Creditor JE: 12/31/2012, First interest payment after restructuring 169 WileyPLUS 170 End of Chapter § Exercise 26 171 29