Chapter 13 Long-Liabilities and Receivables
Reasons for issuance of Long-term Liabilities
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Debt financing may be the only available source of funds.
Debt financing may have a lower cost
Debt financing offers an income tax advantage
The voting privilege is not shared
Leverage – refers to a company’s use of borrowed funds. By investing these funds, the
company expects to earn a return greater than the interest to be paid for their use and tehr
by benefit the stockholders.
Bonds Payable
Bond – is a type of note in which a company agrees to pay the holder the face value at the
maturity date and usually to pay interest periodically at a specified rate on the face value.
Face Value(Par) – is the amount of money that the issuer agrees to pay at maturity.
Maturity Date – is the date on which the issuer of the bond agrees to pay the face value to
the to the holder.
Contract Rate is the rate at which the issuer of the bond agrees to pay interest each period
until maturity.
Bond Certificate – is a legal document that specifies the face value, the annual interest
rate, the maturity date, and other characteristics of the bond issue.
Bond Indenture – is a document (contract) that defines the rights of the bondholders.
Bond Selling Prices
The yield (effective rate) is the market rate at which the bonds are actually sold, which
may be different from contract or stated rate of interest.
Three Alternatives are possible:
1. If the yield is equal to the contract rate, the purchasers of the bonds pay the face
value of the bonds – the bonds are sold at par.
2. If yield is more than the contract rate, the purchasers of the bonds pay less than
the face value of the bonds – the bonds are sold at a discount.
3. If the yield is less than the contract rate, the purchasers of the bonds pay more
than the face value of the bonds – the bonds are sold at a premium.
Recording the Issuance of Bonds
At the time of sale the company records the face value of bonds in a Bonds Payable
account, and it records any premium or discount in a separate account entitled Premium
on Bonds Payable or Discount on Bonds Payable.
Example: Assume the company issues bonds with a face value of $400,000 on the
authorization date at 102.
Cash ( 400,000 x 1.02)
Bonds Payable
Premium on Bonds Payable
408,000
400,000
8,000
Book (Carrying) Value – of a bond issue at any time is the face value plus any
unamortized premium or minus any unamortized discount.
Bonds Issued Between Interest Payment Dates
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Bonds are often sold after their authorization date and between interest payment
periods.
When a company sells bonds between interest dates, to reduce the record keeping
for the first interest payment, the company normally will collect from the
investors both the selling price and the interest accrued on the bonds from the
interest payment date prior to the date of sale.
Example: A company issues $800,000 on March 1, 2001 of 10-year 12% coupon bonds
dated January 1, 2001 at par. Interest is paid semiannually on January 1 and July 1. The
following entry would be recorded on March 1, 2001:
Cash
816,000
Interest Expense
Bonds Payable
16,000
800,000
On July the semiannual interest payment would be recorded:
Interest Expense ($800,000 x 0.12 x 6/12)
Cash
48,000
48,000
It is possible to record the previous transaction by using a liability account that reflects
the fact that part of the proceeds (i.e., the accrued interest) will be repaid in the future.
The following entry represents this:
Cash
816,000
Interest Payable
Bonds Payable
16,000
800,000
On July 1, 2001 the first interest payment would be recorded as follows:
Interest Expense ($800,000 x .12 x4/12)
Interest Payable
Cash
32,000
16,000
48,000
Amortizing Discounts and Premiums
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Effective Interest Method
The effective interest expense amount is computed by multiplying the effective
interest rate time the book value of the bonds at the beginning of the period.
To determine the selling price and the related discount (premium) the effective
rate is applied to both the future principal and periodic interest payments
Amortization is the difference between the amount of interest expense and the
cash payment.
The amount of interest expense using this method reflects a constant rate based
upon the remaining book value of the bonds.
Straight-line Method
When using the straight-line method the discount or premium is amortized to
interest expense in equal amounts each period during the life of the bonds.
The straight-line method results in a constant amount of interest expense each
semiannual period.
Bond Issue Costs
APB Opinion No. 21 requires that a company defer any expenditures connected with a
bond issue such as legal and accounting fees, printing costs, or registration fees.
Accruing Bond Interest
In cases where bonds are issued with interest payments dates that differ from the fiscal
year the matching principle requires than an accrual of interest and partial premium or
discount or amortization be recorded at the end of the fiscal year.
Zero Coupon Bonds are sold at a “deep” discount and pay no interest each period. But
interest expense must be recognized as it is incurred over the period.
Extinguishment of Liabilities
Under FASB Statement No. 125 a liability is considered extinguished for financial
reporting purposes if either of the following occurs:
1. The debtor pays the creditor and is relieved of its obligation for the liability. This
payment may take place at maturity, or prior to maturity by recall or by
reacquisition.
2. The debtor is released legally from being the primary obligor under the liability,
either by law or by the creditor.
Call Provisions allow a company to recall the debt issue at a prestated percentage of the
face value prior to the maturity date.
Bonds with Equity Characteristics
A company may issue bonds that allow creditors to ultimately become shareholders either
by attaching stock warrants to the bonds or including a conversion feature in the bond
indenture.
Stock Warrants – represent rights that enable the security holder to acquire a specified
number of common shares at a given price within a certain time period.
A portion of the proceeds of bonds issued with detachable warrants must be allocated to
the stock warrants and accounted for as additional paid in capital. The allocation made is
as follows:
Amount Assigned = Market Value of Bonds without Warrants x Issuance Price
Bonds
Market Value of Bonds + Market Value
Without Warrants
of Warrants
Amount Assigned = _____Market Value of Warrants_____ x Issuance Price
To Warrants
Market Value of Bonds + Market Value
Without Warrants
of Warrants
Convertible Bonds – at conversion the bondholder exchanges the bonds for a specified
number of common shares and becomes a stockholder.
The conversion may be recorded with either the Book Value Method or the Market
Value Method.
Long-term Notes Payable
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A long-term note is similar to a debenture bond because it represents a future
obligation of the borrower to repay debt, and in many cases no collateral backs
the note.
The note is recorded at its present value and the effective interest method is used
to record the subsequent interest.
The incremental interest rate is the rate that the borrower would be required to pay
to obtain similar financing in the credit market at the time the note is issued.
Notes Payable Issued for Cash
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When a long-term non-interest bearing note is exchanged solely for cash, the note
is assumed to have a present value equal to the cash proceeds.
The difference between the cash proceeds and the face value of the note is
recorded as a discount and amortized over the life of the note by the effective
interest method.
The effective (implicit) interest rate is the rate that equates the future value on the
present value.
Example: Company issues a 3-year non-interest bearing note with a face value of
$8,000 and receives 5,694.24 in proceeds.
Cash
Discounts on Notes Payable
Notes Payable
5,694.24
2,305.76
8,000
Company records interest expense for the first year as follows
Interest Expense ($5,694.24 x 0.12)
Discounts on Notes Payable
683.31
683.31
Notes Payable Exchanged for Cash and Rights or Privileges
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The note is recorded at its present value at the time of issuance by discounting
the maturity value using the incremental interest rate of the borrower.
Interest expense is recorded over the life of the note using the effective
interest method.
The difference between cash proceeds and the present value of the note is
recorded as unearned revenue and revenue is recognized over the life of the
contract using appropriate revenue recognition criteria.
Notes Payable Exchanged for Property, Goods, or Services
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The notes is recorded at the fair value of the property, goods, or services, or
the fair value of the note, whichever is more reliable.
If neither of these fair values is determinable, the note is recorded at its
present value by discounting the future cash flow(s) using the incremental
interest rate of the borrower.
Long-term Notes Receivable
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The note receivable is recorded at the fair value of the property, goods, or services
or the fair value of the note whichever is more reliable.
If neither of these values is reliable, the note is recorded at its present value by
using borrower’s incremental interest rate.