Long-term Debt
A. Long-term debt consists of probable future sacrifices of economic benefits.
These sacrifices are payable in the future, normally beyond one year or the
operating cycle, whichever is longer.
B. These obligations normally require a formal agreement between the parties
involved that often includes certain covenants and restrictions for the
protection of both lenders and borrowers. These covenants and restrictions are
found in the bond indenture or note agreement, and include information related
to amounts authorized to be issued, interest rates, due dates, call provisions,
security for the debt, sinking fund requirements, etc. The important issues related
to long-term debt should always be disclosed in the financial statements or notes.
C. Long-term liabilities include bonds payable, mortgage notes payable, longterm notes payable, lease obligations, and pension obligations. Pension and
lease obligations are covered in ACC 306.
Bonds
A. Bonds are debt instruments of the issuing corporation used by that corporation
to borrow funds from the general public or institutional investors. The use of
bonds provides the issuer an opportunity to divide a large amount of long-term
indebtedness among many small investing units.
B. Bonds payable represent an obligation of the issuing corporation to pay a sum
of money at a designated maturity date plus periodic interest at a specified rate
on the face value. The main purpose of issuing bonds is to borrow for the long
term when the amount of capital needed is too large for one lender to supply.
Bond interest payments are usually made semiannually.
C. Bonds may be sold through an underwriter who either (a) guarantees a certain
sum to the corporation and assumes the risk of sale or (b) agrees to sell the bond
issue on the basis of a commission. Alternatively, a corporation may sell the
bonds directly to a large financial institution without the aid of an underwriter.
Types of Bonds. The various types of bonds attract capital from different investors and
risk takers and satisfy the cash flow needs of issuers.
A. Various issuers: Corporate, US Treasuries & Agencies, Municipals, Sovereigns
B. Various features:
Serial vs. Term – Principal repaid in series of payments or repaid on one date
Fixed vs Floating – Interest rate is constant over the life of the instrument or
adjusts periodically
Secured vs. Unsecured (Debenture) – Backed by collateral or not backed by
collateral
Coupon vs. Zero-Coupon (Non-Interest Bearing) – Periodic payment of interest
or issued at a discount with interest included in repayment amount
Senior vs. Subordinated – High priority or low priority for repayment by a firm in
bankruptcy or liquidation
Registered vs. Bearer – Bonds issued in the name of the owner are registered
and require surrender of the certificate and issuance of a new certificate to
complete a sale. A bearer bond is not recorded in the name of the owner and
may be transferred from one owner to another by mere delivery.
Callable (Redeemable) – Issuer has the right to call (buy) prior to maturity at a
predetermined price
Putable (Retractable) – Investor has the right to put (sell) prior to maturity at a
predetermined price
Convertible Bonds - Issuer and Investor have the right to convert into stock of
the company that issues the bond
Debt issued with detachable warrants - Bond can have an attached warrant,
which gives the investor the right to buy a certain number of shares of the stock
of the company that issues the bond. Warrants are considered detachable,
which means they can be sold or redeemed separately.
Commodity-backed bonds (asset-linked) – Bonds that are redeemable in
measures of a commodity, such as barrels of oil, tons of coal, or ounces of metal
Income bonds – Bonds pay no interest unless the issuing company is profitable
Revenue bonds – Bonds where the interest on them is paid from specified
revenue sources, are most frequently issued by airports, school districts,
counties, toll-road authorities, and governmental bodies.
Valuation of Bonds Payable.
The price of a bond is determined by the interaction between the bond’s stated interest
rate and its market rate. When bonds are sold for more than face value (at a premium)
or less than face value (at a discount), the interest rate actually earned by the investor
is different from the stated rate. The issue price is based on the effective yield or
market rate of interest and is set by economic conditions in the investment market. A
bond’s price is equal to the sum of the present value of the principal and the present
value of the periodic interest.
1. If the stated rate = the market rate, the bond will sell at par (face value).
2. If the stated rate < the market rate, the bond will sell at a discount.
3. If the stated rate > the market rate, the bond will sell at a premium.
Accounting for the issuance of bonds.
A. Discounts and premiums resulting from a bond issue are recorded at the time the
bonds are sold. The amounts recorded as discounts or premiums are amortized
each time bond interest is paid. The time period over which discounts and
premiums are amortized is equal to the period of time the bonds are outstanding
(date of sale to maturity date).
B. To illustrate the recording of bonds sold at a discount or premium, the following
examples are presented. If Aretha Company issued $100,000 of bonds dated
January 1, 2017 at 98, on January 1, 2017, the entry would be as follows:
Cash ($100,000 × .98) ..................................
Discount on Bonds Payable ..........................
Bonds Payable ........................................
98,000
2,000
100,000
If the same bonds noted above were sold for 102, the entry to record the issuance
would be as follows:
Cash ($100,000 × 1.02) .................................
Premium on Bonds Payable .....................
Bonds Payable .........................................
102,000
2,000
100,000
1.
The face value is always reflected in the Bonds Payable account.
2.
When a bond sells at a discount, the difference between the sales price
and the face value is debited to Discount on Bonds Payable, a contra
liability account.
3.
When a bond sells at a premium, the difference between the sales price
and the face value is credited to Premium on Bonds Payable, and
adjunct account to Bonds Payable.
C. Bonds sold between interest dates.
1.
When bonds are issued between interest dates, the purchase price is
increased by an amount equal to the interest earned on the bonds since
the last interest payment date.
2.
On the next interest payment date, the bondholder receives the entire
semiannual interest payment. As a result, the amount of interest expense
to the issuing corporation is the difference between the semiannual interest
payment and the amount of interest prepaid by the purchaser.
3.
The accrued interest is credited to Interest Expense.
4.
For example, assume a 10-year bond issue in the amount of $300,000,
bearing 9% interest payable semiannually on June 30 and December 31,
dated January 1, 2017. If the entire bond issue is sold at par on March 1,
2017, the following journal entry will be made by the seller:
Cash ..............................................................
Bonds Payable .........................................
Interest Expense.......................................
*($300,000 × .09 × 2/12)
304,500
300,000
4,500*
The entry for the semiannual interest payment on July 1, 2017 would be:
Interest Expense ............................................
Cash .........................................................
13,500
13,500
The total bond interest expense for the six month period is $9,000 ($13,500
– $4,500), which represents the correct interest expense corresponding to
the four-month period the bonds were outstanding.
Amortization of bond discounts and premiums.
1. The amortization period for premiums or discounts is the period of time that
the bonds are expected to be outstanding.
2.
Interest expense is increased by amortization of a discount and decreased
by amortization of a premium.
3.
The straight-line method amortizes a constant amount each period.
4.
To illustrate the amortization of the bond discount or premium, assume the
bonds sold in the example above are five-year bonds, and they pay interest
annually. Since the bonds are sold on the issue date (January 1, 2017) they
will be outstanding for the full five years. Thus, the discount or premium
would be amortized over the entire life of the bonds. The entry to amortize
the bond discount at the end of 2017 is:
Interest Expense ...............................................
Discount on Bonds Payable ($2,000 ÷ 5) ....
400
400
........ The entry to amortize the premium is:
Premium on Bonds Payable .............................
Interest Expense .........................................
400
400
Note: Amortization of discount increases interest expense for the period,
and amortization of premium reduces interest expense for the period.
4.
The effective-interest method is the preferred procedure used to calculate
periodic interest expense. The carrying value of the bonds at the beginning
of the period is multiplied by the effective-interest rate to determine the
interest expense. The effective-interest method is best accomplished by
preparing a Schedule of Bond Interest Amortization, which provides the
information necessary for each semiannual entry for interest and discount
or premium amortization. The following relationships are important.
.
(a) Carrying value of bonds = Face value plus premium (or less discount).
(b) Interest payable = Stated Interest rate × Face value of bonds.
(c) Interest expense = Effective-interest rate × Carrying value of bonds.
(d) If a premium exists:
(e) If a discount exists:
Interest Expense
Premium on Bonds Payable
Interest Payable
XX
XX
Interest Expense
Discount on Bonds Payable
Interest Payable
XX
XX
XX
XX
5.
The straight-line method may be used if the results are not materially
different from those produced by the effective-interest method.
6.
Unamortized premiums and discounts are reported with the Bonds
Payable account in the liability section of the balance sheet. Premiums and
discounts are not liability accounts; they are merely liability valuation
accounts. Premiums are added to the Bonds Payable account and
discounts are deducted from the Bonds Payable account in the liability
section of the balance sheet.
Extinguishment of Debt.
A. The extinguishment, or payment, of bonds can be a relatively straightforward
process which involves a debit to the liability account and a credit to cash. The
process can be a complicated one when bonds are extinguished prior to maturity.
B. The reacquisition of debt can occur either by payment to the creditor or by
reacquisition in the open market. At the time of reacquisition, any unamortized
premium or discount, and any costs of issue related to the bonds must be
amortized up to the reacquisition date to avoid misstatement of any resulting gain
or loss on the extinguishment. The difference between the reacquisition price and
the net carrying amount of the debt is a gain (reacquisition price lower) or loss
(reacquisition price greater) from extinguishment.
The difference between the bonds’ net carrying amount and the reacquisition
price is a gain or loss from extinguishment.
1.
Reacquisition price = Price + call premium + reacquisition expenses
2.
Carrying amount =
3.
Gain on redemption of bonds: Carrying amount > reacquisition price
4.
Loss on redemption of bonds: Carrying amount < reacquisition price
Face value ± unamortized premium/discount
– unamortized issuance costs
Accruing Interest on Bonds
A. If the interest payment date does not coincide with the financial statement’s date,
the amortized premium or discount should be prorated by the appropriate number
of months to arrive at the proper interest expense. Interest payable is reported as a
current liability.
Long-Term Notes Payable
A. Accounting procedures for notes and bonds are quite similar. Whenever
the face value of a note does not represent the present value of the
consideration in the exchange, the company must determine the implicit interest
rate to properly record the exchange and the subsequent interest.
B. Notes not issued at face value.
1. Zero-Interest-Bearing Notes.
(a) The implicit interest rate is the rate that equates the cash received
(present value) with the amounts to be paid in the future.
(b) The difference between the face amount and the present value of the
note is the discount which is amortized to interest expense over the life
of the note.
2.
Interest-Bearing Notes.
(a) If a stated interest rate is unreasonable, an imputed interest rate must
be used to determine the present value of the note.
(b) Any discount or premium must be recognized and amortized over the
life of the note.
C. Notes Issued for Property, Goods, or Services.
1. The present value of the debt is measured by the fair value of the property,
goods, or services, or by an amount that reasonably approximates the fair
value of the note. If no interest rate is stated, the amount of interest is the
difference between the face amount of the note and the fair value of the
property.
2.
Imputing an interest rate. The rate that would have resulted if an
independent borrower and lender had negotiated a similar transaction must
be approximated.
D. Mortgage Notes Payable.
1. A promissory note secured by property.
2.
The borrower usually receives cash equal to face value of the note.
3.
If a lender assesses points, the borrower receives less than the face value.
(a) A point is 1% of the notes’ face value.
(b) The existence of points raises the effective interest rate and is treated
as a discount on the mortgage.
4.
Fixed-rate vs. variable-rate mortgages.
E. Fair Value Option.
1. Companies may opt to record fair value in their accounts for most financial
assets and liabilities including bonds and notes. The FASB believes the fair
value measurement provides more relevant and understandable information
than amortized cost.
2. If companies choose the fair value option, noncurrent liabilities are recorded at
fair value, with unrealized holding gains or losses reported as part of net income.
F. Off-balance-sheet financing. An attempt to borrow monies in such a way to
prevent recording the obligations.
1. There are three forms:
a.
Non-consolidated subsidiary.
(1) Because GAAP does not require a subsidiary that is less than 50%
owned to be included in the consolidated financial statements,
companies may omit liabilities held by these subsidiaries.
b.
Special-purpose entity (SPE). An entity created by a company to perform
a special project.
(1) Often called project financing arrangements.
(2) The SPE finances and builds the project while the company that
created the SPE benefits from the asset/project it created. The SPE
reports any liabilities on its books.
c.
Operating leases.
(1) Companies often lease assets instead of buying them to avoid
incurring debt to finance the purchase. The lease contracts can be
structured so that they do not meet the criteria for balance sheet
reporting.
2. Rationale for off-balance-sheet financing.
a.
To attempt to “enhance the quality” of the balance sheet.
b.
To conform to loan covenants.
c.
To “balance” understatement of assets.
3. FASB’s response has been to require increased note disclosure.
G. Presentation and Analysis of Long-Term Debt.
1. Presentation.
a. Long-term obligations are often reported as one amount in the balance
sheet and supported with comments and schedules in the notes.
2.
b.
If the debt matures within one year, report it as a current liability, unless
retirement is accomplished using noncurrent assets.
c.
Note disclosures generally indicate the nature of the liabilities, maturity
dates, interest rates, call provisions, conversion privileges, restrictions
imposed by creditors, and assets pledged as security.
d.
Future payments for sinking fund requirements and maturity amounts of
long-term debt during each of the next five years should be disclosed.
Analysis of long-term debt.
a. Solvency. Ability to pay interest and principal on long-term debt as it
comes due.
b.
Debt to Assets ratio =
Total Debt
Total A ssets
(1) The higher the percentage, the greater the risk that the company may
be unable to pay its maturing debt.
c.
Times Interest Earned =
Net Income  Interest Expense Income Tax Expense
Interest Expense
(1) The ability to meet interest payments as they come due.
H. Troubled-Debt Restructurings.
1. Settlement of debt at less than its carrying amount.
a. Debtor (creditor) records gain (loss) equal to the excess of the carrying
amount of the payable (receivable) over the fair value of the assets
transferred.
b.
2.
Debtor also recognizes gain or loss equal to the difference between the fair
value of the assets transferred and their book value.
Continuation of debt with a modification of terms.
a. Debtor records no gain when the total future cash flows exceed the prerestructuring carrying amount of the debt.
b.
Debtor records a gain when the pre-restructuring carrying amount of the
debt exceeds the future cash flows.