Long-Term Financial Liabilities
Prepared by:
Patricia Zima, CA
Mohawk College of Applied Arts and Technology

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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• 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

• 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

• 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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• 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

• 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
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•
•
•
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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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
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
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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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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• A premium effectively decreases the annual interest expense for the corporation
• The discount effectively increases the annual interest expense for the issuing corporation
13

• 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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• 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

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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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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• 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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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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The journal entry to record the bond issuance is:
Cash
Bonds Payable
92,278
92,278
20

The journal entry for first semi-annual payment is:
Bond Interest Expense
Bonds Payable
Cash
4,614
614
4,000
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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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The journal entry to record the bond issuance is:
Cash
Bonds Payable
108,530
108,530
23

The journal entry for first semi-annual payment is:
Bond Interest Expense
Bonds Payable
Cash
3,256
744
4,000
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• 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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• 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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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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• 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
28

• Where additional value is being transferred – either for marketable securities or nonmarketable securities, must book separately
Example
29

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

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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• 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
32

• 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)
33

• 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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• 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

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

Bonds Payable
Loss on Redemption of Bonds
785,600
32,000
Unamortized Bond Issue Costs 9,600
Cash 808,000
37

• 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 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

• 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
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• 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

• Current versus long-term
– Debt to be refinanced treated as long-term
• Debt versus equity
– Dependent on nature of the instrument
43

• 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

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

• 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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Copyright © 2007 John Wiley & Sons Canada, Ltd.
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