Intermediate Accounting, Eighth Canadian Edition

Chapter 14

Long-Term Financial Liabilities

Prepared by:

Patricia Zima, CA

Mohawk College of Applied Arts and Technology

Long-Term Financial Liabilities

Nature of

Long-term

Measurement and Valuation

Debt

Bonds

Notes payable

Bonds/Notes issued at par

Extinguishment

/Derecognition

Repayment before maturity date

Recognition

Perspectives

Appendix and

Presentation

14A-Troubled

Debt

Off-balancesheet financing

Impairment of

Loans/ Notes receivable

Types of bonds

/notes

Bond ratings

Discounts and premiums Exchange of debt instruments

Special situations

Defeasance

Issuance costs

Presentation

Long-term debt

Note disclosures

Troubled debt restructuring

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Issuing Long-Term Debt

• Obligations not payable within one year, or one business operating cycle —whichever is longer

• Examples include:

– Bonds payable

– Long-term notes

– Mortgages

– Pension liabilities

– Lease liabilities

• Often with restrictive covenants (terms) attached

3

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 semiannually) at a stipulated rate on the face value

• A bond issue may be sold:

• either through an investment banker, or

• by private placement

4

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 Long-Term Debt

• Bearer (coupon) bonds : are freely transferable by current owner

• Secured and unsecured debt : secured by collateral (real estate, stocks)

• Serial bonds : mature in instalments

• Callable bonds : give issuer right to call and retire debt prior to maturity

• Income and Revenue bonds : interest payments tied to some form of performance

• Deep-discount bonds : little or no interest payments; sold at substantial discount

• Convertible bonds : can be converted into other corporate securities for a specified time after issue

6

Bond Ratings

• Companies such as DBRS, Moody’s

Investors Service, Standard & Poor’s 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

7

Bond Valuation:

Determining Bond Prices

Price of a bond issue is determined by finding the present value (PV) of future cash flows :

• the PV of the interest payment annuity (at the or coupon rate of interest), plus stated

• the PV of the redemption (face, par) value,

• both discounted at the market (yield) rate of interest in effect at issue date

When market rate

 stated rate

 bond sells at discount

When market rate

 stated rate

 bond sells at premium

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Bond Valuation: Bond Price

Calculation

Given:

 Face value of bond issue: $100,000

 Term of issue: 5 years

 Stated interest rate: 9% per year, payable end of the year

 Market rate of interest: 11%

Determine the issue price of the bonds.

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Year 1

Bond Valuation:

Bond Price Calculation

Year 2 Year 3 Year 4 Year 5

$9,000 $9,000 $9,000 $9,000 $9,000

Interest annuity

Face Value

$100,000

Discount the future cash flows using the market (yield) rate of interest

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Year 1

Bond Valuation:

Bond Price Calculation

Year 2 Year 3 Year 4 Year 5

$9,000 $9,000 $9,000 $9,000 $9,000

$33,263

Discount at market rate , 11%

$9,000 x 3.69590

plus

$ 59,345

Discount at market rate , 11%

$100,000 x 0.59345

=$92,608 is the issue price

$100,000

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Entries for the Issuance of Bonds

Sold at Par

Cash

Bonds Payable

1,000

1,000

Sold at a Premium

Cash

Bonds Payable

1,100

1,100

Sold at a Discount

Cash

Bonds Payable

900

900

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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

13

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

2) Effective interest

• allocates the discount or premium over the bond term (i.e. amortizes the discount or premium)

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Amortizing the Bond

Premium/Discount

• The total discount or premium amortized is the same under both methods

• The straight-line method of amortizing is acceptable under GAAP only if the results are not materially different from those produced by using the effective interest method

15

Straight-Line Method—Discount

Given:

Face Value = $800,000

Coupon Rate = 10%

The annual discount amortization =

$24,000

10 years = $2,400

Discount = $24,000

Bond Maturity = 10 years

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

Coupon Rate = 10%

Premium = $24,000

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 (using market rate) of the carrying value of the bond

• 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 straightline method

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Effective Interest Method

Calculation

Face Value = $100,000

Market Rate = 10%

Bond Maturity = 5 years

Discount = $7,722

Coupon Rate = 8%

Year

1 92,278

2 92,892

3 93,536

4 94,213

5 94,924

6 95,670

7 96,454

8 97,276

9 98,140

10 99,047

A

Carrying

Value

B

Discount

Amortization

= C - D

-614

-645

-677

-711

-746

-784

-823

-864

-907

-952

C

Interest

Paid

Face Value

* 4%

4,000

4,000

4,000

4,000

4,000

4,000

4,000

4,000

4,000

4,000

D

Interest

Expense

=A *

5%

4,614

4,645

4,677

4,711

4,746

4,784

4,823

4,864

4,907

4,952

E

Discount

Balance

F

Carrying

Value

Face

Value - E

7,108 92,892

6,464 93,536

5,787 94,213

5,076 94,924

4,330 95,670

3,546 96,454

2,724 97,276

1,860 98,140

953 99,047

0 100,000

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Effective Interest Method

The journal entry to record the bond issuance is:

Cash

Bonds Payable

92,278

92,278

20

Effective Interest Method

The journal entry for first semi-annual payment is:

Bond Interest Expense

Bonds Payable

Cash

4,614

614

4,000

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Effective Interest Method

Calculation

Face Value = $100,000

Market Rate = 6%

Bond Maturity = 5 years

Discount = $8,530

Coupon Rate = 8%

Year

A

Carrying

Value

1 108,530

2 107,786

3 107,019

4 106,230

5 105,417

6 104,579

7 103,717

8 102,828

9 101,913

10 100,971

B

Premium

Amortization

= C - D

744

766

789

813

837

863

888

915

943

971

C

Interest

Paid

Face Value

* 4%

4,000

4,000

4,000

4,000

4,000

4,000

4,000

4,000

4,000

4,000

D

Interest

Expense

=A *

3%

3,256

3,234

3,211

3,187

3,163

3,137

3,112

3,085

3,057

3,029

E

Premium

Balance

F

Carrying

Value

Face

Value - E

7,786 107,786

7,019 107,019

6,230 106,230

5,417 105,417

4,579 104,579

3,717 103,717

2,828 102,828

1,913 101,913

971 100,971

0 100,000

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Effective Interest Method

The journal entry to record the bond issuance is:

Cash

Bonds Payable

108,530

108,530

23

Effective Interest Method

The journal entry for first semi-annual payment is:

Bond Interest Expense

Bonds Payable

Cash

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 collected from the bondholder in addition to the issue price of the bonds

• At the specified interest date, interest is paid for the entire interest period (semi-annual or annual)

• Premium or discount is also amortized from the date of sale of bonds to the end of the interest period

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Deep Discount/Zero-Interest-

Bearing Bonds/Notes

• 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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Deep Discount/Zero-Interest-

Bearing Bonds/Notes

Example:

• 10,000 3-year zero-interest-bearing marketable bond issued

• Cash received at issuance: $7,722

• Discount equal to:

Less: Cash

$10,000

7,722

$ 2,278

• Implied interest rate therefore: 9%

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Deep Discount/Zero-Interest-

Bearing Bonds/Notes

• Non-marketable securities

– Cash consideration may 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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Note Issued for Cash and Other Rights

• Where additional value is being transferred – either for marketable securities or nonmarketable securities, must book separately

Example

29

Note Issued for Cash and Other Rights

Given:

• Government gives a 5 year, $100,000 note payable to a company on January 1 st 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

30

Note Issued for Cash and Other Rights

Books of the Issuer:

Cash 100,000

Note Payable

Building - Government Grant

PV of 100,000 at 10%, (n=5) = 62,902

100,000 – 62,902 = 37,908

62,902

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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Bond Issue Costs

• Those costs incurred to physically issue the bonds

– e.g., costs paid to the broker, legal costs, commissions

– Does not include debt premiums/discounts, financing costs or holding costs

• The company has a choice to either:

1. Immediately recognize costs in net income or

2. Add the costs to the carrying value of the debt and amortize the costs over the life of the debt (similar to bond discounts/premiums)

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Extinguishment of Debt

• When debt is paid out prior to maturity

– Reacquisition, requires gain or loss to be recorded

• May be for full amount of debt, or a portion

• At the time of reacquisition all outstanding premiums, discounts, and issue costs are amortized to the date of reacquisition

• Any gain or loss from the reacquisition is reported with other gains/losses (does not qualify as an extraordinary item)

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Extinguishment of Debt

• 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

• Refunding of bonds : when a bond issue is called in and replaced with a new issue (at a lower rate of interest)

35

Extinguishment of Debt: Example

Given:

• Existing debt:

• Called and cancelled at:

$800,000

$808,000

• Unamortized discount: $ 14,400

• Unamortized bond issue costs: $ 9,600

Note : Both discount and bond issue costs have been amortized up to the date of cancellation of debt.

Give the journal entry for the extinguishment.

36

Extinguishment of Debt:

Example

Bonds Payable

Loss on Redemption of Bonds

785,600

32,000

Unamortized Bond Issue Costs 9,600

Cash 808,000

37

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

– The debt may be derecognized

• “ In-substance defeasance ” occurs when the creditor is not aware of the trust arrangement

– CICA Handbook, Section 3855 does not permit derecognition of the debt in these situations

38

Off-Balance-Sheet Financing

• Off-balance-sheet financing represents borrowing arrangements that are not recorded

• The amount of debt reported in the balance sheet does not include such financing arrangements – this is not acceptable and is usually done to improve certain financial ratios

(such as debt-equity ratio) = biased reporting

• Different forms of off-balance-sheet financing:

1.Non-consolidated subsidiaries

2.Special Purpose Entities (SPE) or Variable Interest Entities (VIE)

3.Operating Leases

39

Non-consolidated subsidiaries

• 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

40

Special Purpose Entities (SPE) or

Variable Interest Entities (VIE)

• 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

41

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)

• In general, increased note disclosure is accounting profession’s response to offbalance sheet financing

42

Presentation of Long-Term Debt

• Current versus long-term

– Debt to be refinanced treated as long-term

• Debt versus equity

– Dependent on nature of the instrument

43

Note Disclosure

• Include:

– Nature of the liability

– Maturity date

– Interest rate

– Call provision

– Conversion privileges

– 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 balance sheet

• Fair value of the long-term debt should also be disclosed if practical to estimate

44

Long-Term Debt 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

45

International Perspective

• Canadian GAAP and International standards on Long-term debt and Financial Instruments are substantially converged

• “One of the long-term objectives relating to liabilities is to measure all financial instruments, including debt, at fair value, and require that gains and losses be recognized in net income.”

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