S t I c e | S t I c e | S k o u s e n
Chapter 12
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT
©
2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

1. Understand the various classification and measurement issues associated with debt.
2. Account for short-term debt obligations, including those expected to be refinanced, and describe the purpose of lines of credit.
3. Apply present value concepts to the accounting for long-term debts such as mortgages.
4. Understand the various types of bonds, compute the price of a bond issue, and account for the issuance, interest, and redemption of bonds.

CHOOSE the method of financing
ISSUE the debt
+/-
PAY interest
ACCOUNT for the specific aspects of the type of debt
RETIRE the debt

• The obligation of a particular entity to transfer assets or provide services.
– Must be the result of past transactions or events.
– Probable transfer of assets (or services) must be in the future.

• Current Liabilities-
Paid within one year or the operating cycle, whichever is longer.
• Noncurrent
LiabilitiesNot paid within one year or the operating cycle, whichever is longer.

Look at Exhibit 12-3. The
2004 current ratio of
McDonald’s is only
0.81. How will
McDonald’s most likely meet its current obligations as they come due?

For measurement purposes, liabilities can be divided into three categories:
1. Liabilities that are definite in amount.
2. Estimated liabilities.
3. Contingent liabilities.

• Short-Term obligations are due within one year or an operating cycle.
• Account Payable -the amount due for the purchase of materials.
• Notes Payable – a formal written promise to pay a sum of money in the future, also known as a promissory note.

• A short-term obligation that is expected to be refinanced on a longterm basis should not be reported as a current liability
• FASB Statement No. 6 requires that both of the following conditions be met before a short-term obligation may be properly excluded from the current liability classification:

• An ability to refinance may be demonstrated by:
– Actually refinancing the obligation during the period between the balance sheet date and the date the statements are issued.
– Reaching a firm agreement that clearly provides for refinancing on a long-term basis.

• The terms of the refinancing agreement should be non-cancelable as to all parties.
• The terms of the refinancing agreement should extend beyond the current year.
• The company should not be in violation of the agreement at the balance sheet date or the date of issuance.
• The lender or investor should be financially capable of meeting the refinancing requirements.

• Line of credit- is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing.
• A company with an established line of credit can access funds quickly without the
“red tape”.
• Once the line of credit is used to borrow money, the company has a formal liability
(current or noncurrent).

• A liability should be reported at the amount that would satisfy the obligation on the balance sheet date.
• For a long-term obligation, this amount is the present value of the
• The division of these payments into interest and principal components is a process called loan amortization.

• Mortgage- a loan backed by an asset that serves as collateral for the loan.
• If the borrower cannot repay the loan, the lender has the legal right to claim the mortgaged asset and sell it in order to recover the loan amount.
• Secured loan- similar to a mortgage, a loan backed by assets as collateral and can be claimed by the lender if the borrower defaults.
– There is a reduction in risk for the lender with a secured loan, thus a reduced interest cost for the borrower.

• Reasons management may choose to issue bonds instead of stock:
1. Present owners remain in control of the corporation.
2. Interest is a deductible expense in arriving at taxable income; dividends are not.
3. Current market rates of interest may be favorable relative to stock market prices.
4. The charge against earnings for interest may be less than the amount of dividends that might be expected by shareholders.

• Disadvantages and limitations of issuing debt securities:
1. It is only possible to use debt financing if the company is in satisfactory financial condition.
2. Interest obligations must be paid regardless of the company’s earnings and financial position.
3. If a company has losses and is unable to raise cash to pay interest payments, secured debt holders may take legal action.

• There are three main considerations in accounting for bonds:
1. Recording the issuance or purchase.
2. Recognizing the applicable interest during the life of the bonds.
3. Accounting for the retirement of bonds either at maturity or prior to the maturity date.

• Bond Certificates- commonly referred to as bonds are issued in denominations of $1,000.
• Face Value- the amount that will be paid on a bond at maturity date. Also known as par value or maturity value.
• Bond indenture- a group contract between the corporation and the bondholders.

• Term bonds- Bonds that mature in one lump sum on a specified future date.
• Serial bonds- Bonds that mature in a series of installments at future dates.
• Collateral trust bonds- Bonds usually secured by stocks and bonds of other corporations owned by the issuing company.
• Unsecured (debenture) bonds- Bonds for which no specific collateral has been pledged.

• Registered bonds- Bonds for which the issuing company keeps a record of the names and addresses of all bondholders and pays interest only to those individuals whose names are on file.
• Bearer (coupon) bonds- Unregistered bonds for which the issuer has no record of current bondholders, but instead pays interest to anyone who can show evidence of ownership.

• Zero-interest bonds- Bonds that do not bear interest but instead are sold at significant discounts.
• Junk bond- High-risk, high-yield bonds issued by companies in a weak financial condition.
• Commodity-backed bonds- Bonds that may be redeemed in terms of commodities.
• Callable bonds- Bonds for which the issuer reserves the right to pay the obligation prior to the maturity date.

• Bond discount- The difference between the face value and the sales price when bonds are sold below their face value.
 Bond premiumThe difference between the face value and the sales price when bonds are sold above their face value.

Yield
8% Premium
Bond
Stated
Interest
Rate
10%
10% Face Value
12% Discount

Ten-year, 8% bonds of $100,000 are to be sold on the bond issue date. On that date, the effective interest rate for bonds of similar quality and maturity is 10%, compounded semiannually.
Part 1 Present value of principle (maturity value):
Maturity value of bond after 10 years
(20 semiannual periods)
Effective interest rate = 10% per year
(5% per semiannual period)
Part 2: Present value of 20 interest payments:
$100,000
$37,689
Semiannual payment, 4% of $100,000
Effective interest rate, 10% per year
(5% per semiannual period)
4,000
$49,849
Total present value (market price) of bond $87,538

In computing the market price for bonds, what is the only thing for which the stated rate of interest is used?

Issuer’s Books
1/1 Cash 100,000
Bonds Payable 100,000
7/1 Interest Expense 4,000
Cash 4,000 Investor’s Books
12/31 Interest Expense 4,000
Cash 4,000
Bonds 100,000
Cash 100,000
Cash 4,000
Interest Revenue 4,000
Cash 4,000
Interest Revenue 4,000

On January 1, $100,000, 8%, 10-year bonds were issued for $87,538 (which provided an effective interest rate of 10% to the investor).
Issuer’s Books
Jan. 1 Cash 87,538
Discount on Bonds Payable 12,462
Bonds Payable 100,000
Investor’s Books
Jan. 1 Bond Investment
Cash
87,538
87,538

On January 1, $100,000, 8%, 10-year bonds were issued for $107,106 (which provided an effective interest rate of 7% to the investor).
Issuer’s Books
Jan. 1 Cash
Prem. on Bonds Payable
Bonds Payable
107,106
7,106
100,000
Investor’s Books
Jan. 1 Bond Investment
Cash
107,106
107,106

On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two months has accrued on the bonds.
Mar. 1
Issuer’s Books
Bond Investment 101,333
Bonds Payable
$100,000 x 0.08 x 2/12
100,000
1,333
July 1 Interest Expense
Interest Payable
Cash
2,667
1,333
4,000
$100,000 x 0.08 x 4/12

On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two months has accrued on the bonds.
Investor’s Books
Mar. 1 Bond Investment
Interest Receivable
Cash
100,000
1,333
101,333
July 1 Cash
Interest Receivable
Interest Revenue
4,000
1,333
2,667

• The market acts to adjust the stated interest rate to a market or effective interest rate.
• The periodic interest payments made by the issuer are not the total interest expense.
• An adjustment to interest expense
( amortization ) associated with the cash payment is necessary to reflect the effective interest being incurred on the bonds.
• There are two methods used to amortize the premium/ discount:
– Straight Line Method
– Effective Interest Method

Previously, $100,000 of 8% bonds were issued at
$87,538 (a discount of $12,462). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.
July 1
Issuer’s Books
Interest Expense
Cash
4,623
4,000
Dec 31 Interest Expense 4,623
Disc on Bonds Payable 623
Cash 4,000

Previously, $100,000 of 8% bonds were issued at
$87,538 (a discount of $12,462). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.
Investor’s Books
July 1 Cash
Bond Investment
Interest Revenue
4,000
623
4,623
Dec 31 Interest Receivable
Bond Investment
Interest Revenue
4,000
623
4,623

Previously, $100,000 of 8% bonds were issued at
$107,106 (a premium of $7,106). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.
July 1
Issuer’s Books
Interest Expense
$7,106/120 x 6 months
3,645
Cash 4,000
Dec 31 Interest Expense 3,645
Premium on Bonds Payable 355
Cash 4,000

Previously, $100,000 of 8% bonds were issued at
$107,106 (a premium of $7,106). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.
Investor’s Books
July 1 Cash
Bond Investment
Interest Revenue
4,000
355
3,645
Dec 31 Interest Receivable
Bond Investment
Interest Revenue
4,000
355
4,623

Consider again the $100,000, 8%,
10-year bonds sold for $87,538.
The effective rate for the bonds is
10%.
Period One
Effective rate for semiannual period
Stated rate per semiannual period
Interest amount ($87,538 x 0.05) $4,377
Interest payment ($100,000 x 0.04) 4,000
Discount amortization
5 %
4 %
$ 377

Consider again the $100,000, 8%,
10-year bonds sold for $87,538.
The effective rate for the bonds is
10%.
Period Two
Effective rate for semiannual period
Stated rate per semiannual period
Interest amount ($87,915 x 0.05) $4,396
Interest payment ($100,000 x 0.04) 4,000
Discount amortization
$87,538 + $377
5 %
4 %
$ 396

Consider again the $100,000, 8%,
10-year bonds sold for $107,106.
The effective rate for the bonds is
7%.
Period One
Effective rate for semiannual period
Stated rate per semiannual period
Interest payment ($100,00 x 0.04) $4,000
Interest amount ($107,106 x 0.35)
Discount amortization
3.5 %
4 %
3,749
$ 251

Consider again the $100,000, 8%,
10-year bonds sold for $107,106.
The effective rate for the bonds is
7%.
Period Two
Effective rate for semiannual period
Stated rate per semiannual period
Interest payment ($100,00 x 0.04) $4,000
Interest amount ($106,855 x 0.35)
Discount amortization
3.5 %
4 %
3,740
$ 260
$107,106 - $251

Effective-Interest Method—
Premium
A B C D E
($100,000 x 04) (E x 0.035) (A – B) (D – C) ($100,000+ D)
Prem.
# Payment Int. Exp.
Amort.
Unamort.
Prem.
Bond
Book
$7,106 $107,106

Effective-Interest Method—
Premium
A B C D E
($100,000 x 04) (E x 0.035) (A – B) (D – C) ($100,000+ D)
Prem.
Unamort.
# Payment Int. Exp.
Amort.
Prem.
1 $4,000 $3,749 $251
Bond
Book
$7,106 $107,106
6,855 106,855
$107,106 x 0.035

Effective-Interest Method—
Premium
A B C D E
($100,000 x 04) (E x 0.035) (A – B) (D – C) ($100,000+ D)
Prem.
Unamort.
# Payment Int. Exp.
Amort.
Prem.
1 $4,000 $3,749 $251
2 $4,000 $3,740 $260
Bond
Book
$7,106 $107,106
6,855
6,595
106,855
106,595
$106,855 x 0.035

Effective-Interest Method—
Premium
A B C D E
($100,000 x 04) (E x 0.035) (A – B) (D – C) ($100,000+ D)
Prem.
Unamort.
# Payment Int. Exp.
Amort.
Prem.
1 $4,000 $3,749 $251
2 $4,000 $3,740 $260
3 $4,000 $3,731 $269
4 $4,000 $3,721 $279
5 $4,000 $3,712 $288
Bond
Book
$7,106 $107,106
6,855
6,595
6,326
106,855
106,595
106,326
6,047 106,047
5,759 105,759

• Insert exhibit 12-7

When preparing a bond amortization schedule like the one that follows, there are certain numbers within that schedule that you know without having to do any elaborate computations.
Which ONE of the following numbers can be determined using a very simple computation?

1. Bonds may be redeemed by the issuer by purchasing the bonds on the open market or by exercising the call provision (if available).
2. Bonds may be converted , that is, exchanged for other securities.
3. Bonds may be refinanced by using the proceeds from the sale of a new bond issue to retire outstanding bonds.

Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on
February 1, 2007, at 97. The carrying value of the bonds is $97,700 as of this date.
Interest payment dates are January 31 and
July 31.
Investor’s Books
Feb. 1 Bonds Payable
97,000
700
$97,700
97,000
$ 700
2,300
97,000
Bond Redemption

• Convertible debt securities usually have the following features:
1. An interest rate lower than the issuer could establish for nonconvertible debt.
2. An initial conversion price higher than the market value of the common stock at time of issuance.
3. A call option retained by the issuer
• Convertible debt gives both the issuer and the holder advantages.

Assume that 500 ten-year bonds, face value $1,000, are sold at 105
($525,000). The bonds contain a conversion privilege that provides for exchange of a $1,000 bond for 20 shares of stock, par value $1 .

Debt and Equity Not Separated
Cash
Bonds Payable
Premium on Bonds Payable
525,000
Selling price of bond without conversion feature
500,000
25,000
Debt and Equity Separated
Cash
Discount on Bonds Payable
Bonds Payable
Paid-In Capital Arising from
Bond Conversion Feature
525,000
20,000
500,000
45,000

Investor’s Books
Nov. 1 Investment in HiTec Co.
Common Stock
Investment in HiTec
10,400
Co. Bonds
Gain on Conversion of
HiTec Co. Bonds
9,850
550
The investor may choose not to recognize a gain or a loss. If so the investor would debit
Investment in HiTec Co. Common Stock for
&9,850.

Issuer’s Books
Nov. 1 Bonds Payable
Loss on Conversion of
10,000
Bonds
Common Stock, $1 par
550
Paid-In Capital in Excess of Par Value
Discount on Bonds Payable
400
10,000
150

• Off-Balance-Sheet-Financing- procedures to avoid disclosing all debt on the balance sheet in order to make the company’s financial position look stronger.
• Common techniques used:
– Leases
– Unconsolidated subsidiaries
– Variable interest entities (VIEs)
– Joint ventures
– Research and development arrangements
– Project financing arrangements

• Debt-to-Equity Ratio- measures the relationship between the debt and equity of an entity.
Formula: total debt ÷ total stockholders’ equity
• Debt Ratio- indicates a company’s overall ability to repay its debts.
Formula: total liabilities ÷ total assets.
• Times Interest Earned- shows a company’s ability to meet interest payments.
Formula: income before interest expense and income taxes ÷ interest expense for the period .

• Companies may want to disclose additional information about long-term debt in the notes like:
– Nature of the liabilities
– Maturity dates
– Interest rates
– Methods of liquidation
– Conversion privileges
– Sinking fund requirements
– Borrowing restrictions
– Assets pledged,
– Dividend limitations

Troubled debt restructuring exists only if the “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.” (SFAS 15.2
)

FMV Asset
< debt?
Yes
Remove debt and asset from books.
No Not a troubled debt restructure.
Restructuring Gain
= Debt – FMV Asset
Disposal Gain/Loss
= FMV Asset – Book
Value of Asset

FMV Equity
< debt?
No Not a troubled debt restructure.
Yes
Remove debt and asset from books and record new equity.
Restructuring Gain
=Debt – FMV Equity

FMV Asset
> loan?
No
Remove loan from books and record asset at
FMV.
Yes
Not a troubled debt restructure.
Restructure Loss =
Loan – FMV Asset

Total future payments < debt book value?
Yes
Reclassify the debt and amortize using effective interest method.
Interest rate is the implicit rate.
No
Recognize gain on restructuring.
Write-down debt to sum of future cash flows.
Record all future payments as principal payments.