Chapter 10: Bonds and Long-Term Notes
Liabilities is a probable future transfer of economic benefits arising from present obligations to other
entities resulting from past transactions or events.
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Some liabilities are not contractual obligations and may not be payable in cash.
Notice that the definition of liability involves the present, the future and the past. It is a present
responsibility, to transfer assets or services in the future, caused by a transaction or other event
that already has happened.
Nature of a Long-Term Debt
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Obligations that extend beyond one year or the operating cycle, whichever is longer.
Loan agreement restrictions, Mirror image of an asset, reported at present value, accrue interest
expense
Bonds
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Issuer
o Debit cash, Credit Bonds payable
Investor
o Debit Investment in Bonds, Credit Cash
Determining the selling Price
o Bond Price = Present Value of the Principal payable at maturity + Present Value of the
Periodic Cash Interest Payments
o Stated interest rate is
 Below market rate- the bonds sells at a discount (cash received is less than
principal amount)
 Equal to market rate- the bonds sells at principal amount (cash received is equal
to principal amount)
 Above market rate – the bonds sells at a premium (cash received is greater than
principal amount)
o Journal Entries at Issuance of Bonds issued at a discount
 Issuer- Debit cash (discounted amount), debit Discount on bonds payable, credit
Bonds Payable
 Investor- debit Investment in Bonds (face amount), credit discount on bond
investment, credit cash
Determining Interest- Effective Interest Method
o Interest accrues on an outstanding debt at a constant percentage of the debt each period.
Interest each period is recorded as the effective interest rate multiplied by the
outstanding balance of the debt (during the interest period).
o Interest is recorded as expense to the issuer and revenue to the investor.
o The difference between the interest using the stated rate and the interest using the
effective rate increases the liability and is reflected as a reduction in the discount.
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Effective interest by allocating the discount (or premium) on a straight-line basis is not
permitted under IFRS, although it is allowed under US GAAP.
Journal Entries- Effective Interest Method
 Issuer- Debit Interest Expense, Credit Discount on Bonds Payable, Credit Cash
 Investor- Debit Cash, Debit Discount on Bond Investment, Credit Interest Revenue
Since less cash is paid each period than the effective interest, the unpaid difference
increases the outstanding balance of the debt.
Debt Transaction Cost
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Transaction costs include fees and commissions paid to advisers and intermediaries, payment of
levies to regulatory agencies and stock exchanges, and specific types of taxes paid to
governments.
Debt premiums or discounts, financing costs or an entity’s administrative or holding costs are not
transaction cost.
Debt transaction costs are recognized as yield to the effective interest rate.
The costs are kept on the statement of financial position in a contra/linked account to the debt
account.
As the costs reduce the net proceeds from the debt issue, they increase the effective borrowing
rate.
Not all transaction costs qualify for yield adjustments. For example, service fees incurred
periodically to maintain, but not originate, the loan are expensed off in the periods incurred.
Transaction costs that are an integral part of the effective interest rate are amortized, together
with premiums or discounts, over the expected life of the debt or the period in which the befits
relating to the costs are realized, whichever is shorter.
Option to Report Liabilities at fair value
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Financial liabilities that are held-for-trading must be measured at fair value at the end of each
reporting period.
A company is not required to, but has the option to measure, non-trading financial assets and
liabilities, including bonds and notes, at fair value if any of the following conditions exist.
o An accounting mismatch exists between financial assets and financial liabilities.
o Management of financial assets and liabilities requires the use of fair value information.
o IFRS is more restrictive than US GAAP which permits the issuer to apply the fair value
option unconditionally.
o The option need not be applied to all financial instruments but may be applied selectively.
o If a company chooses the option to report at fair value, a change in fair value will create
a gain or loss. Any portion of that gain or loss that is a result of a change in the “credit
risk” of the debt, rather than a change in general interest rates, is reported, not as part of
net income but instead as other comprehensive income.
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Fair value may be determined by discounting the bond’s remaining interest and principal
payments by the current market interest rate for a bond with similar credit risk
characteristics.
The loss in fair value is adjusted either directly to bonds payable or indirectly with a credit
to a valuation allowance (or contra) account. If the adjustment is made directly to the
bond, the entry is:
 Debit Loss in Fair Value (income statement), Credit Bonds payable
If general interest rates have not change, we assume the change in fair value is due to the
credit risk associated with the bonds and report the loss in OCI.
 Debit Unrealized holding loss (OCI), Credit Bonds Payable
If any portion of the fair value change is due to a change in general interest rates, that
portion would be reported in net income.
Long-Term Notes
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When a company borrows cash from a bank and signs a promissory note, the firm’s liability is
reported as a note payable.
The present value techniques are used for valuation and interest recognition.
The procedures are similar to those we encountered with bonds.
Installment Notes
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Installment payments are equal amount each period.
Periodic reduction of the balance is sufficient that at maturity the note is completely paid.
For installment notes, the outstanding balance of the notes does not eventually become its
principal amount. Instead, at the maturity date, the balance is zero.
Each amount includes both an amount that represents interest and an amount that represents a
reduction of principal.
Borrower- Debit Interest Expense, Debit Notes Payable, Credit Cash
Financial Statement Disclosures:
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Fair value of financial instruments must be disclosed either in:
 Body of financial statement
 Disclosure notes
For all long-term borrowing, disclosures should include the aggregate amounts maturing
and sinking fund requirement (if any) in time bands for the remaining contractual period.
Early Extinguishment of Debt
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Debt retired at maturity results in no gains or losses but debt retired before maturity may result
in a gain or loss on extinguishment.
Cash Proceeds – Book Value = Gain or Loss
Debit Bonds Payable, Debit Loss on early extinguishment, Credit Discount on Bonds Payable,
Credit Cash
Decision Maker’s Perspective
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Long term debt impacts several key financial ratios:
o Rate of return on shareholder’s equity = Net Income/ Shareholder’s Equity
o Time Interest Earned Ratio = Net income + interest + taxes / Interest
o Debt to equity ratio = Total Liabilities/Shareholders’ equity
o Rate of return on assets = net income/total assets
Convertible Bonds
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Some bonds may be converted into ordinary shares at the option of the holder. They are
accounted for as both debt and equity
o Substance over Form: convertible bonds are no different from a pure bond with a
detachable warrant or stand-alone call option.
o Bifurcation: debt and equity components are accounted for separately even though each
is not separable.
o Bond component: the effective rate of the convertible bond is the market interest rate of
a pure bond of similar credit risk characteristics.
Accounting for convertible Bonds at Issuance
 The entire issue price of the convertible bonds is split between debt and equity,
which are recorded separately.
 Debit Cash, Debit Discount on Bonds Payable, Credit Convertible Bonds Payable,
Credit Equity Option
 If and when the bondholder exercises his or her option to convert the bonds into
shares:
o The bonds and the equity options are removed from the accounting
records.
o New shares are issued and are recorded at the amount equal to the book
value of the bonds and the book value of the equity options.
o Debit Convertible bonds payable, Debit Equity Option, Credit Discount on
bonds payable, Credit Share capital