INTERMEDIATE ACCOUNTING
TENTH CANADIAN EDITION
Kieso • Weygandt • Warfield • Young • Wiecek • McConomy
CHAPTER 14
Long-Term Financial
Liabilities
Prepared by:
Lisa Harvey, CPA, CA
Rotman School of Management,
University of Toronto
CHAPTER 14
LONG-TERM FINANCIAL LIABILITIES
After studying this chapter, you should be able to:
•
•
•
•
•
•
•
Understand the nature of long-term debt financing arrangements.
Understand how long-term debt is measured and accounted for.
Understand when long-term debt is recognized and derecognized,
including how to account for troubled debt restructurings.
Explain how long-term debt is presented on the statement of
financial position.
Identify disclosure requirements.
Calculate and interpret key ratios related to solvency and liquidity.
Identify major differences in accounting standards between IFRS
and ASPE, and what changes are expected in the near future.
Copyright © John Wiley & Sons Canada, Ltd.
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Long-Term Financial Liabilities
Understanding
Debt
Instruments
Measurement
•Bonds and notes
payable
•Discounts and
premiums
•Credit ratings
•Special situations
•Defeasance
•Types of
companies that
have significant
debt financing
•Information for
decision-making
•Bonds and notes
issued at par
Recognition
and
Derecognition
Presentation, IFRS/ASPE
Disclosure,
Comparison
and Analysis •A comparison of
•Repayment
before maturity
date
•Presentation
IFRS and ASPE
•Disclosures
•Looking ahead
•Exchange of debt
instruments
•Analysis
•Troubled debt
restructurings
•Defeasance
revisited
•Off-balance sheet
financing
Copyright © John Wiley & Sons Canada, Ltd.
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Issuing Long-Term Debt
• Obligations not payable within one year, or
one business operating cycle—whichever
is longer
• Examples include:
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–
–
–
–
Bonds payable
Long-term notes payable
Mortgages
Pension liabilities
Lease liabilities
• Often with restrictive covenants (terms)
attached
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Bonds
• Most common type of long-term debt
• A bond indenture is a promise (by the
lender to the borrower) to pay:
• a sum of money at the designated date, and
• periodic interest (usually paid semi-annually)
at a stipulated rate on the face value.
• A bond issue may be sold:
• either through an investment banker, or
• by private placement.
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Notes Payable
• Similar in nature to bonds
– Require repayment of principal at a future date
– Require periodic interest payments
• The difference is that notes do not normally
trade on public markets
• Accounting for bonds and notes is the same in
many respects
• Like a bond, a note is recorded at the PV of
future interest and principal, and any
premium/discount is amortized over the life of
the note
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Types of Bonds/Notes
• Bearer (coupon) bonds: are freely transferable by current
owner
• Secured debt: secured by collateral (real estate, stocks)
• Serial bonds: mature in instalments
• Income and revenue bonds: interest payments tied to
some form of performance
• Deep-discount bonds: little or no interest payments; sold
at a substantial discount
• Callable bonds: give issuer right to call and retire debt
prior to maturity
• Convertible bonds: can be converted into other
corporate securities
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Bond Ratings
• Companies such as Moody’s Investors
Service and Standard & Poor’s
Corporation assess credit ratings of
company bonds and preferred shares
• Bonds ratings range from a quality of
“Prime” to “Very speculative”
• AAA rating indicates a rating of “Prime”,
while a B rating indicates a “very
speculative” rating
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Defeasance
• Sufficient funds set aside (i.e. in a trust) to pay
off principal and interest of debt
• “Legal defeasance” occurs when the creditor no
longer has claim on the assets of the original
issuer
– Trust held responsible for repayment
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Types of Companies with
Significant Debt Financing
• Financing can be obtained from borrowing,
issuing equity (shares) or using internally
generated funds
• Capital-intensive industries have a greater
ability to borrow funds because the loans
are secured by the underlying tangible
assets
– Examples include transportation and hotel
companies
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Information for Decision-Making
• It is important for companies to monitor
financial ratios in order to ensure that they
take advantage of leverage without
becoming overextended
– Cash flows must be managed in order to
continue to operate, maximize profit and
benefit from opportunities
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Long-Term Financial Liabilities
Understanding
Debt
Instruments
Measurement
•Bonds and notes
payable
•Discounts and
premiums
•Credit ratings
•Special situations
•Defeasance
•Types of
companies that
have significant
debt financing
•Information for
decision-making
•Bonds and notes
issued at par
Recognition
and
Derecognition
Presentation, IFRS/ASPE
Disclosure,
Comparison
and Analysis •A comparison of
•Repayment
before maturity
date
•Presentation
IFRS and ASPE
•Disclosures
•Looking ahead
•Exchange of
debt instruments
•Analysis
•Troubled debt
restructurings
•Defeasance
revisited
•Off-balance
sheet financing
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Bond Measurement:
Determining Bond Prices
• The price of a bond is determined by finding the
present value (PV) of future cash flows:
• the PV of the interest payments (at the stated ,
coupon or nominal rate of interest) plus
• the PV of the principal amount (also called the face
value, par value or maturity value)
• Both amounts are discounted at the
market (yield) rate of interest in effect at
issue date
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Bond Measurement:
Determining Bond Prices
• When the effective yield (market rate) =
stated rate  bond sells at par
• When the effective yield (market rate) 
stated rate  bond sells at a discount
• When the effective yield (market rate) 
stated rate  bond sells at a premium
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Bond Measurement: Bond Price
Calculation
Given:
• Face value of bond issue: $100,000
• Term of issue: 5 years
• Stated interest rate: 9% per year,
payable annually at year end
• Market rate of interest: 11%
Determine the issue price of the bonds
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Bond Measurement:
Bond Price Calculation
Year 1
$9,000
Year 2
$9,000
Year 3
$9,000
Year 4
$9,000
Interest
annuity
Year 5
$9,000
Face Value
$100,000
Discount the future cash flows
using the effective yield
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Bond Measurement:
Bond Price Calculation
Year 1
$9,000
$33,263
plus
$ 59,345
Year 2
Year 3
$9,000
$9,000
Year 4
Year 5
$9,000
$9,000
Discount at effective yield, 11%
$9,000 x 3.69590
Discount at effective yield, 11%
$100,000 x 0.59345
$100,000
=$92,608 is the issue price
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Amortizing the Bond
Premium/Discount
• A premium effectively decreases the
annual interest expense for the
corporation
• The discount effectively increases the
annual interest expense for the issuing
corporation
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Amortizing the Bond
Premium/Discount
• Two methods available for amortization
1)Straight-Line
• Allocates the same amount of discount (or
premium) to each interest period
• Acceptable under ASPE
2)Effective Interest
• Allocates the discount or premium over the
bond term (i.e. amortizes the discount or
premium)
• Required under IFRS
• The total discount or premium amortized is
the same under both methods
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Straight-Line Method—Discount
Given:
Face Value = $800,000
Stated Rate = 10%
Discount = $24,000
Bond Maturity = 10 years
The annual discount amortization =
$24,00010 years = $2,400
The entry to record the annual discount amortization would
be:
Interest Expense
2,400
Bonds Payable
2,400
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Straight-Line Method—Premium
Given:
Face Value = $800,000
Premium = $24,000
Stated Rate = 10%
Bond Maturity = 10 years
The annual premium amortization =
$24,00010 years = $2,400
The entry to record the annual premium amortization would
be
Bonds Payable
2,400
Interest Expense
2,400
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Effective Interest Method
• Produces a periodic interest expense
equal to a constant percentage of the
carrying value of the bond
– The percentage used is the effective yield
• The amortization of the discount or
premium is determined by comparing the
interest expense with the interest paid
• Total interest expense over the life of the
bond is the same as that using the
straight-line method
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Effective Interest Method Calculation:
Discount
Face Value = $100,000
Market Rate = 10%
Bond Maturity = 5 years
Period
1
2
3
4
5
6
7
8
9
10
Discount = $7,722
Coupon Rate = 8%
A
B
Carrying
Value
Discount
Amortization
92,278
92,892
93,536
94,213
94,924
95,670
96,454
97,276
98,140
99,047
=C-D
-614
-645
-677
-711
-746
-784
-823
-864
-907
-952
-7,722
semi-annual
C
D
E
F
Interest Paid
Interest
Expense
Discount
Balance
Carrying
Value
Face Value *
4%
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
40,000
=A * 5%
4,614
4,645
4,677
4,711
4,746
4,784
4,823
4,864
4,907
4,952
47,722
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7,108
6,464
5,787
5,076
4,330
3,546
2,724
1,860
953
0
Face Value E
92,892
93,536
94,213
94,924
95,670
96,454
97,276
98,140
99,047
100,000
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Effective Interest Method
• The journal entry to record the bond
issuance is:
Cash
Bonds Payable
92,278
92,278
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Effective Interest Method
• The journal entry for first semi-annual
payment is:
Bond Interest Expense
Bonds Payable
Cash
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4,614
614
4,000
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Effective Interest Method Calculation:
Premium
Face Value = $100,000
Market Rate = 6%
Bond Maturity = 5 years
Year
Discount = $8,530
Coupon Rate = 8%
A
B
Carrying
Value
Premium
Amortization
=C-D
1
2
3
4
5
6
7
8
9
10
108,530
107,786
107,019
106,230
105,417
104,579
103,717
102,828
101,913
100,971
744
766
789
813
837
863
888
915
943
971
8,530
semi-annual
C
D
E
F
Interest Paid
Interest
Expense
Premium
Balance
Carrying
Value
Face Value *
4%
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
40,000
=A * 3%
3,256
3,234
3,211
3,187
3,163
3,137
3,112
3,085
3,057
3,029
31,470
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7,786
7,019
6,230
5,417
4,579
3,717
2,828
1,913
971
0
Face Value E
107,786
107,019
106,230
105,417
104,579
103,717
102,828
101,913
100,971
100,000
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Effective Interest Method
• The journal entry to record the bond
issuance is:
Cash
Bonds Payable
108,530
108,530
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Effective Interest Method
• The journal entry for first semi-annual
payment is:
Bond Interest Expense
Bonds Payable
Cash
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3,256
744
4,000
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Bonds Issued Between Interest Dates
• Interest for the period between the issue
date and the last interest date is paid by
the bondholder in addition to the issue
price of the bonds
• At the specified interest date, interest is
paid for the entire interest period (semiannual or annual)
• Premium or discount is also amortized
from the date of sale
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Non-Market Rates of Interest
(Marketable Securities)
• If bond issued for cash, and is marketable,
its fair value = cash received by issuer
• Implicit interest rate is the rate that causes
the PV (of future cash flows) to equal cash
received
• Difference between face amount and PV is
the discount
– Amortized over life of the bond/note
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Non-Market Rates of Interest
(Marketable Securities) Example
• $10,000 3-year zero-interest-bearing
marketable bond issued
• Cash received at issuance: $7,722
• Implied interest rate is therefore 9%
• Discount equal to:
Maturity Value
$10,000
Less: Cash Received
7,722
$ 2,278
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Non-Market Rates of Interest
(Non-Marketable Instruments)
• Non-marketable Instruments
– Cash consideration might not be equal to fair
value – there might be additional value being
transferred
– Must measure fair value of loan by
discounting the cash flows using a market rate
of interest
– Any difference is booked to net income unless
it meets the definition of an asset or liability
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Non-Market Rates of Interest (NonMarketable Instruments) Example
Given:
• Government gives a 5 year, $100,000 note payable to a
company on January 1st to help it finance the
construction of a building
• The note is zero-interest bearing
• The market rate is 10%
• Recipient company has an additional benefit beyond the
debt financing – the government is forgiving the interest
that the company would normally be charged. This is a
government grant.
Journalize in issuer’s books
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Non-Market Rates of Interest (NonMarketable Instruments) Example
Books of the Issuer:
Cash
100,000
Notes Payable
Building - Government Grant
62,092
37,908
(PV of 100,000 at 10%, (n=5) = 62,092)
(100,000 – 62,092 = 37,908)
• The discount is amortized to interest expense over the
term of note
• The government grant is amortized to net income as the
building is depreciated
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Notes Issued for Property, Goods, and
Services
• If the issued debt is a marketable security, the
value of the transaction would be equal to fair
value of the marketable security
• If the issued debt is not a marketable security:
– May try to value debt by discounting cash flows at
market rate of interest, or
– May use the fair value of the property, goods,
services.
• Any discount or premium amortized over life of
the note
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Fair Value Option
• Long-term debt is generally measured at
amortized cost however it can also be
measured at fair value
– IFRS allows the fair value option only if it
results in more relevant information
– ASPE allows the fair value option for all
financial instruments
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Long-Term Financial Liabilities
Understanding
Debt
Instruments
Measurement
•Bonds and notes
payable
•Discounts and
premiums
•Credit ratings
•Defeasance
•Types of
companies that
have significant
debt financing
•Information for
decision-making
•Bonds and notes
issued at par
Recognition
and
Derecognition
•Repayment
before maturity
•Special situations date
•Exchange of debt
instruments
Presentation, IFRS/ASPE
Disclosure,
Comparison
and Analysis •A comparison of
•Presentation
IFRS and ASPE
•Disclosures
•Looking ahead
•Analysis
•Troubled debt
restructurings
•Defeasance
revisited
•Off-balance sheet
financing
Copyright © John Wiley & Sons Canada, Ltd.
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Extinguishment of Debt
• Extinguishment of debt is recorded when:
– The debtor pays the creditor, or
– The debtor is legally released from paying the
creditor (due to cancellation, expiry etc.)
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Repayment before Maturity Date
• When debt is paid out prior to maturity, the
amount paid is called the reacquisition
price
– May be for the full amount of debt or a portion
– Includes any call premium and expenses
• At the time of reacquisition all outstanding
premiums, discounts, and issue costs are
amortized to the date of reacquisition
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Repayment before Maturity Date
• If the net carrying amount of the debt is
more than the reacquisition price, this
results in a gain from extinguishment
• If the reacquisition price exceeds the net
carrying amount of the debt, this results in
a loss from extinguishment
• Any gain or loss from the reacquisition is
reported with other gains and losses
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Repayment before Maturity Date:
Example
Given:
• Existing debt:
$800,000
• Called and cancelled at:
$808,000
• Unamortized discount:
$ 14,400
Note: Discount has been amortized up to the date
of cancellation of debt.
Give the journal entry for the extinguishment.
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Repayment before Maturity Date:
Example
Bonds Payable
785,600
Loss on Redemption of Bonds 22,400
Cash
808,000
(800,000 – 14,400 = 785,600)
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Troubled Debt Restructurings
• When a creditor grants a favourable
concession to a debtor
• Two basic types of transactions
1. Settlement of debt at less than carrying value
2. Continuation of debt with modification of terms
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Settlement of Debt
• Old debt, as well as all related discount,
premium and issuance costs are removed
from books (derecognized)
• A gain is usually recognized since creditor
generally makes concessions in
settlement of troubled debt (settled at less
than carrying value)
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Substantial Modification of Terms
• If debt is continued with substantial modification
of terms, the transaction is treated like a
settlement
– Old liability is derecognized
– New (substantially modified) liability is recognized
– The difference between the old and new liability is
recorded as a gain
• Modification of terms is substantial if either:
– Discounted PV under new terms is at least 10%
different from discounted PV of remaining cash flows
under old debt, or
– Old debt is legally discharged and there is a new
creditor
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Non-Substantial Modification of Terms
• No gain or loss recognized
• New effective interest rate must be found
– Imputed using the rate that equates the
carrying value of old debt to cash flows of
newly arranged debt
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Defeasance Revisited
• “Legal defeasance” occurs when the creditor no
longer has claim on the assets of the original
issuer
– The debt may be derecognized
• “In-substance defeasance” occurs when the
creditor is not aware of the trust arrangement
– The debt may not be derecognized
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Off-Balance-Sheet Financing
• Off-balance-sheet financing represents
borrowing arrangements that are not recorded
• The amount of debt reported in the statement of
financial position does not include such
financing arrangements
– This is not acceptable and is usually done to improve
certain financial ratios (such as debt-equity ratio)
• In general, increased note disclosure is
the accounting profession’s response to
off-balance sheet financing
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Non-consolidated entities
• Under present GAAP, a parent company
does not have to consolidate an
investment in a company where <50%
owned and no control
• Therefore, the liabilities of the company
would not be reflected on the balance
sheet of the parent company, although the
parent may be ultimately liable for the debt
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Special Purpose Entities (SPEs) or
Variable Interest Entities (VIEs)
• A company may create a special purpose
entity or variable interest entity to perform
a special project or function
• This is a concern if SPEs/VIEs are used
primarily to disguise debt
• As a general rule, the companies should
be consolidated if the company is the main
beneficiary of the SPE/VIE
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Operating Leases
• Another way to reduce a company’s debt
is to lease rather than own
• If a lease is considered an operating
lease, the company would need to record
rent expense each period with note
disclosure (further covered in chapter 20)
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Long-Term Financial Liabilities
Understanding
Debt
Instruments
Measurement
•Bonds and notes
payable
•Discounts and
premiums
•Credit ratings
•Defeasance
•Types of
companies that
have significant
debt financing
•Information for
decision-making
•Bonds and notes
issued at par
Recognition
and
Derecognition
•Repayment
before maturity
•Special situations date
•Exchange of debt
instruments
Presentation, IFRS/ASPE
Disclosure,
Comparison
and Analysis •A comparison of
•Presentation
IFRS and ASPE
•Disclosures
•Looking ahead
•Analysis
•Troubled debt
restructurings
•Defeasance
revisited
•Off-balance sheet
financing
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Presentation of Long-Term Debt
• Current versus long-term
– Debt to be refinanced treated as current
unless specific refinancing conditions met
• Debt versus equity
– Dependent on nature of the instrument
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Disclosures
• Include:
–
–
–
–
–
–
–
Nature of the liability
Maturity date
Interest rate
Call provision
Conversion privilege
Any restrictions imposed
Assets designated or pledged as security
• Any assets pledged as security for the debt should be
shown in the assets section of the statement of financial
position
• Fair value of the long-term debt should also be disclosed
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Analysis
Debt to Total Assets:
Total debt
Total assets
• Level or percentage of assets that is
financed through debt
Times Interest Earned:
Income before income taxes and interest
Interest expense
• Measures ability to meet interest payments
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Long-Term Financial Liabilities
Understanding
Debt
Instruments
Measurement
•Bonds and notes
payable
•Discounts and
premiums
•Credit ratings
•Defeasance
•Types of
companies that
have significant
debt financing
•Information for
decision-making
•Bonds and notes
issued at par
Recognition
and
Derecognition
•Repayment
before maturity
•Special situations date
•Exchange of debt
instruments
Presentation, IFRS/ASPE
Disclosure,
Comparison
and Analysis •A comparison of
•Presentation
IFRS and ASPE
•Disclosures
•Looking ahead
•Analysis
•Troubled debt
restructurings
•Defeasance
revisited
•Off-balance sheet
financing
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Looking Ahead
• There are several current projects by IASB
and FASB that could impact future
accounting standards for long-term debt:
– Financial instruments project
– Financial instruments with the characteristics
of equity
– Conceptual framework project
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