Chapter 14
Bonds and Long-Term Notes
Topics of Long-Term Liabilities
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Issuance of bonds (at a premium or discount)
Fair value option of bonds
Issuance of bonds between interest payment
dates
Extinguishment of debt
Bonds issued with detachable stock warrants
Convertible Bonds (including Induced
Conversion)
Long-term Notes Payable
Troubled Debt Restructuring
Long-Term Liabilities
2
Long-Term Liabilities


Present value concept:
Present value of $1 is the value today of $1 to be
received at some future date, given a specific
interest rate.
Example:
1. What is the present value of $100 to be received
a year from now given an annual market interest
rate of 10%?
P.V.  (1+10%) = $100
P.V. = $100/1.1
= $100  0.9091
= $90.91
Long-Term Liabilities
3
Long-Term Liabilities
2. What is the present value of $100 to be received
two years from now given an annual interest rate of
10%?
P.V  (1+10%)  (1+10%) = $100
P.V  (1+10%)2 = $100
P.V.  1.21 = $100
P.V.
= $100 / 1.21
= $100  0.8264
= $82.64
Long-Term Liabilities
4
Annuity:

Receiving (or paying)a constant amount of
money at the end of each period (equal time
internal) for a given number of periods
$100
$100
$100
$100
$100
1 year

Receiving $100 every year for the following 5
years. (period = 1 year) (starting a year from
now)
Long-Term Liabilities
5
Present Value (P.V.) of an Annuity:
1. Using the example above given a10% Interest rate:
P.V. of the first $100 =
$100  0.9091 = $90.91
P.V. of the second $100 =
$100  0.8264 = $82.64
P.V. of the third $100 =
$100  0.7513 = $75.13
P.V. of the fourth $100 =
$100  0.6830 = $68.30
P.V. of the fifth $100 =
$100  0.6209 = $62.09
Total
3.7907 $379.07
Long-Term Liabilities
6
Present Value (P.V.) of an Annuity
(contd.):



The P.V. of $100 annuity receiving
every year for the following 5 years,
starting a year from now =>
$100 * 3.7907 = $379.07
The P.V. of this annuity can be
obtained from an annuity table under
10%, 5 periods.
Long-Term Liabilities
7
Present Value (P.V.) of an Annuity
(contd.):
2. What is the P.V. of $300 annuity receiving
every 6 months for the following 30
months, starting 6 months from now ? The
annual interest rate is 12%.
P.V. = $300 x 4.2124 = 1,263.7
Annuity Table, 5 periods at 6%
(30/6=5)
(12%/2=6%)
Long-Term Liabilities
8
Corporate Bonds:



Bonds are securities issued by a
corporation to borrow money from the
public (many lenders).
This is a source to raise funds.
The corporation will receive cash when
bonds are issued.
Long-Term Liabilities
9
Corporate Bonds:


The face value of the bonds must be
repaid to the bondholders on the
maturity date of the bonds.
Also, the bond issuers will pay interests
to the bondholders periodically (i.e.,
semi-annually).
Long-Term Liabilities
10
Bonds Payable


Long-Term Liability: if bonds mature in
more than one year.
Short-Term Liability: if bonds mature in
less than one year
Long-Term Liabilities
11
Bond Indenture


Bond Indenture is an agreement between the
bond issuer and investors stating the
following:
Interest rate of bonds;
Interest Payment dates;
The maturity date of bonds;
 The type of bonds: callable, convertible,..
The indenture is held by a trustee appointed
by the issuing firm to represent the rights of
the bondholders.
Long-Term Liabilities
12
Bond Covenant



Bond Covenant is a contractual provision in
a bond indenture (source: financial dictionary).
Financial covenant: requiring issuers to
maintain financial ratios such as debt/equity
ratio and the interest coverage ratio at a
certain level.
Non-financial covenant: requiring the
disclosure of certain financial information.
Long-Term Liabilities
13
The Process of Bond Issuance
1. Receive the approval from the
stockholders and regulatory authorities
(i.e., the SEC).
2. Print bond certificates and write indenture
(to set the terms of bond issue such as the
stated interest rate, the interest payment
date and the maturity date…)
3. Make a public announcement of its intent
to sell the bonds on a particular date.
Long-Term Liabilities
14
The Process of Bond Issuance (cont.)
4. Negotiate the appropriate selling price
with the underwriters based on the terms
of bond issue (i.e., the stated inters rate),
the general bond market conditions, the
risk of the bonds and the expected state
of the economy.
Long-Term Liabilities
15
The Process of Bond Issuance (cont.)
5. The underwriter will determine the
effective interest rate (yield) and thus,
the selling price that it believes best
reflects the current market condition and
the risk the bond for a particular bond
issue.
6. The underwriter will either purchase the
bonds from the issuing company and
resell them to the public or sell these
bonds for a commission.
Long-Term Liabilities
16
The Process of Bond Issuance (cont.)


Companies can sell the entire issue of
bonds to an underwriter or sell it to a single
investor (i.e., a pension fund) (referred to
as a private placement).
Any expenditures connected with a bond
issue (legal fee, printing costs, accounting
fee, underwriter's charges …) should be
deferred and amortized as expense over
the life of the bond using a straight line
method.
Long-Term Liabilities
17
The Process of Bond Issuance (Contd.)
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The yield is the market rate (effective rate) for
the bond issue.
The yield is often different from the stated
interest rate as a result of :
1) different opinion between the underwriter
and the company, or
2) a change in the economic conditions
between the date the terms were set and the
date the bonds were issued.
Long-Term Liabilities
18
The Process of Bond Issuance (Contd.)
Three possible outcomes of bond issuance:
1. Stated rate = effective rate
=> the bonds are sold at par
2. Stated rate < effective rate
=> bonds are sold at discount
3. Stated rate > effective rate
=> bonds are sold at premium
Long-Term Liabilities
19
Units of bonds:

At $1,000 or $5,000 denominations

Price of bonds: stated at 100s

Example: $1,000 issued at 98
The issuing price is $1,000  98 =
$980

Long-Term Liabilities
20
Types of bonds:
On the basis whether the bonds are secured:

Secured Bonds

Unsecured Bonds (Debenture bonds)
On the basis of how the interests are paid:

Registered Bonds

Coupon Bonds
Long-Term Liabilities
21
Types of bonds:
On the basis of how the bonds mature:

Term Bonds

Serial Bonds

Convertible Bonds

Callable Bonds
Long-Term Liabilities
22
Asset-Backed Securities and
Securitization of Assets


Asset-backed securities: securities (i.e.,
commercial paper, bonds) issued based
on (or backed by) certain assets (i.e.,
mortgage receivables).
A conduit can be set up by a bank as an
independent entity to take the title of
financial assets (i.e., mortgage or credit
card receivables) of companies.
Long-Term Liabilities
23
Asset-Backed Securities and
Securitization of Assets (contd.)


The conduit issues securities (i.e.,
commercial paper) backed by those
financial assets.
The cash generated from the sale of
asset-backed securities goes back to the
companies who put the assets into
conduits. Source: ’Conduits’ in Need of a Fix by D. Reilly and C.
Mollenkamp, WSJ , 8/30/2007

As a result, those financial assets are
securitized.
Long-Term Liabilities
24
Bond Ratings (Source: BestVest
Investments, Ltd)
Moody'
S&P
s
Aaa
Aa
A
Baa
Meaning
Best quality, with the smallest amount of risk.
AAA
Issuers are extremely stable and dependable.
High quality, with a slightly higher degree of
AA
long-term risk.
A
High to medium quality, with many strong
attributes but with some risk exposure to
changing economic conditions.
Medium quality, currently adequate but with
BBB
significant risk possible
over the long term.
Long-Term Liabilities
25
Bond Ratings (contd.)
Ba
B
Caa
Ca
BB
B
Some speculative element, with moderate security but
not well safeguarded for the long haul.
Able to pay now but with a significant risk of default in
the future.
CCC Poor quality with a clear danger of default.
CC
High speculative nature, often in or near default.
C
C
Lowest rated, poor prospects of payment going forward
but may be current in payments.
--
D
In default.
Long-Term Liabilities
26
Determination of Bond Price

The obligations of bond issuers:
(1) to pay the principal when bond
matures on the maturity date.
(2) to pay interests periodically (i.e.,
semiannually) over the life the bond.

Present value of a bond: the present
value of future net cash flows related to
the bond using the effective interest rate.
Long-Term Liabilities
27
Determination of Bond Price (Contd.)


Bond Price = the present value of the
bond.
Present value of bonds => The sum of
(1) the present value of the principal plus
(2) the present value of the periodic
interests
using the effective interest rate (not the
stated interest rate) as the discount rate.
Long-Term Liabilities
28
Determination of Bond Price (Contd.)


Discount rate = effective rate = market
rate =yield
 This rate depends on the riskiness
of the issuer, the general state of
the economy, the duration of the
bond, etc.
In general, a higher risk will result in a
higher effective rate.
Long-Term Liabilities
29
Determination of Bond Price (Contd.)

Bonds Issued at Face Value
When the stated interest rate equals the
effective interest rate, the bond price
will equal the face value.
Long-Term Liabilities
30
Determination of Bond Price (Contd.)
Example 1:
Page company issued a 5-year term bond
with a face amount $100,000 and a stated
annual interest rate of 10%.
Interests are paid semiannually.
Assume that the annual effective interest
rate demanded by investors for bonds of
this level of risk is also 10%, what is the
present value of the bond (the bond
price)?

Long-Term Liabilities
31
Determination of Bond Price (Contd.)
(1)P.V. of the principal ($100,000 mature in 5
years, discount rate 5%, 10 periods):
The annual effective rate = 10% (10%/2= 5%)
$100,000  0.6139 = $61,390
(2)P.V. of the interests received semiannually
for 10 periods (annuity, discount rate = 5%,
10 periods)
$5,000  7.7217 = 38,608.5
annuity table, 5%, 10periods
Long-Term Liabilities
32
Determination of Bond Price (Contd.)

The P.V. of the bond = the sum of (1) and (2)
(1) + (2)
= $61,390 + 38,608.5 = $100,000
Note: The semiannual interest paid
= $100,000  5% = $5,000
the annual stated interest rate, not the effective
rate!!
Long-Term Liabilities
33
Determination of Bond Price (Contd.)

Therefore, when the stated rate equals the
effective rate (the discount rate), the bond
price (the P.V. of bonds) equals the face
value.
J.E. (when bonds are issued at face value)
Cash
100,000
Bonds payable
100,000
Long-Term Liabilities
34
Bond Issued at A Discount


When the stated interest rate is less than
the effective interest rate, the present
value of a bond will be less than its face
value.
Example 2: Use the same example as on
page 28, except that the effective rate is
12%, rather than 10% to compute the
present value of the bond.
Long-Term Liabilities
35
Bond Issued at A Discount (Contd.)

Since the interests are paid semiannually, the
discount rate is 6% with 10 periods.
(1)P.V. of the principal = $100,000 .5584 = $55,840

P.V. table, 6%, 10periods
(2) P.V. of the semiannual interest:
$5,000  7.3601 = 36,800.5

Annuity table, 6%, 10periods
P.V. of the bond = (1) + (2)
$55,840 + 36,800.5 = $92,640.5
Long-Term Liabilities
36
Bond Issued at A Discount (Contd.)

$92,640.5 < $100,000 (Discount = $7359.5)
P.V. of bond < Face vale
=> when the stated rate is less than the effective
rate (i.e., 10% < 12%), the P.V. of the bond will
be less than the face value.

J.E. (when bonds are issued at discount)
Cash
92,640.5
Discount on Bonds
7,359.5
Bonds Payable
100,000
Long-Term Liabilities
37
Bond Issued at A Discount (Contd.)
Question:
What is the total interest expense of this bond
(issued at Discount)?
Cash payment by the
issuer
($150,000)
Cash received from issuing
the bond (at Discount)
92,640.5
Interest Expense
$57,359.50*

Discount would increase the actual interest expense and needs to be
amortized over the life of the bond.
*Interest Expense
= interest payment + Discount
= $50,000 + 7,359.50
$57,359.50
Long-Term=Liabilities
38
Bond Issued at A Premium


When the stated interest rate is higher than
the effective interest rate demanded by the
investors for the level of the risk of the
bonds, the present value of the bonds would
be greater than its face value.
Example 3: use the same example as on
page 26, except that the effective interest
rate is 8%. (the stated interest rate is still at
10%)
Long-Term Liabilities
39
Bond Issued at A Premium (Contd.)

Compute the P.V. of the bond:
Since the interests are paid
semiannually, the discount rate would
be 4% and the discounting periods are
10 periods.
(1) P.V. of the principal:
$100,000 x 0.6756 = $67,560
Long-Term Liabilities
40
Bond Issued at A Premium (Contd.)
(2) P.V. of the semiannual interest:
$5,000 x 8.1109 = $40,554.5
P.V. of the bond = (1) + (2)
= $67,560 + 40,554.5 = $108,114.5
$108,114.5 > $100,000 (Premium =
8,114.5)
Long-Term Liabilities
41
Bond Issued at A Premium (Contd.)
Example 3
J.E. (When Bonds are issued at Premium)
Cash
108,114.5
Bonds Payable
100,000
Premium on Bonds Payable
8,114.50

Long-Term Liabilities
42
Bond Issued at A Premium (Contd.)

Interest Expense= interest payments - Premium
= $5,000 x 10 - 8,114.5
= $41,885.5
(Premium will decrease the interest expense.)
Long-Term Liabilities
43
Bond Issued at A Premium (Contd.)


A premium account: an adjunct account
to the bonds payable account and is
shown as an addition to the bonds
payable account.
A discount account: a contra account to
the bonds payable and is shown as a
deduction from the bonds payable.
Long-Term Liabilities
44
Bond Issued at A Premium (Contd.)


Book value (carrying value) of the bond
issued:
the face value minus any unamortized
discounts or plus any unamortized
premiums.
If an effective interest method is used to
amortize the discount (or premium), the
book value equals the present value when
the effective interest rate remains
unchanged.
Long-Term Liabilities
45
Accounting for Bonds Payable -Bonds Are
Issued at Par

The information of example 1 on page 28 is
summarized below with some additional information:
Issuing Company:
Page Company
Stated Interest:
10% (annual)
Effective Interest:
10% (annual)
Date of Issuance:
2/1/x2
Date of Maturity:
2/1/x7
Interest Payment Dates: 2/1 and 8/1
Face Value:
$100,000
P.V. of the Bond:
$100,000
Long-Term Liabilities
46
Accounting for Bonds Payable - Bonds
Are Issued at Par (Contd.)

J.E.
2/1/x2
8/1/x2
Cash
B/P
Interest Expense
Cash
100,000
100,000
5,000
5,000
12/31/x2
Adjusting entry for 5-month interest
expense occurred but not paid. The interest
payment dates are 2/1 and 8/1).
Interest Expense
4,167
Interest payable
4,167
Long-Term Liabilities
47
Accounting for Bonds Payable - Bonds
Are Issued at Par (Contd.)

(Reversing Entry)
1/1/x3 Interest Payable
4,167
Interest Expense
4,167
2/1/x3 Interest Expense
5,000
Cash
5,000
(If no reversing entry recorded on 1/1/x3, the J.E. of
2/1/x3 would be:
Interest Expense
833
Interest Payable
4,167
Cash
5,000
Long-Term Liabilities
48
Accounting for Bonds Payable - Bonds
Are Issued at Par (Contd.)
8/1/x3
Interest Expense
5,000
Cash
5,000
12/31/x3

Adjusting entry for the 5-month unrecorded interest
expense
Interest Expense
4,167
Interest payable
4,167
Long-Term Liabilities
49
Accounting for Bonds Payable - Bonds
Are Issued at Par (Contd.)








1/1/x4 Reversing Entry
2/1/x4 (Interest payment)
8/1/x4 (Interest payment)
12/31/x4 (Adjusting)
1/1/x5 (Reversing)
:
12/31/x6 (Adjusting)
1/1/x7 (Reversing)
2/1/x7 Interest Expense
5,000
Cash
Bonds Payable
100,000
cash
(Bond Retirements
at Maturity)
Long-Term Liabilities
5,000
100,000
50
Accounting for Bonds Payable - Bonds
Are Issued at A Discount







Information of example 2 is summarized below
with some additional information:
Stated Interest = 10% (annual)
Effective Interest = 12% (annual)
Date of Issuance = 1/1/x2 (sold on 1/1/x2)
Date of Maturity = 1/1/x7
Interest Payment Dates = 6/30 and 12/31
Face Value = $100,000
P.V. of the Bond = 92,640.50 (as computed
earlier)
Long-Term Liabilities
51
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)



Discount = $100,000 - 92,640.5 = 7,359.50
This discount would increase the interest expense
and would be amortized over the life of the bond -5
year, 10 periods)
Amortization methods:
1. Straight-Line: the Discount would be amortized
equally over the life of the bond.
i.e., Amortization in 10 periods:
$7349.5010 = $735.95
Therefore, the interest expense every period is
$5,000 + 7,35.95 = $5,735.95
Semiannual
Interest Payment
the amortized Discount
Long-Term Liabilities
52
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)

Total Interest expense
= 5,735.95 x 10 = $5,7359.5
= 50,000 + 7,359.5

Int. payment

Discount
2. Effective Interest Method
Interest Expense
= P.V. of Bond  effective rate
Long-Term Liabilities
53
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
J.E (Bonds are issued at a discount and use the
straight-line method to amortize the discount)
1/1/x2 Cash
92640.50
Discount on B/P
7359.50
B/P
100,000
6/30/x2 Interest Expense
5,736
Cash
5000*
Discount on B/P
735.95**
12/31/x2 Interest Expense
5,736
Cash
5,000
Discount on B/P
735.95

Long-Term Liabilities
54
Accounting for Bonds Payable -Bonds Are
Issued at A Discount (Contd.)
* Interest Payment = semiannual interest = $100,000 x
10% x 1/2
** Amortization of Discount over 10 periods (7359.50/10)
***Interest Expense = Interest Payment Amortized
Discount.
6/30/x3
Same J.E. as recorded on 6/30/x2
12/31/x3
Same J.E. as recorded on 6/30/x2
6/30/x4
Same J.E. as recorded on 6/30/x2
12/31/x4
Same J.E. as recorded on 6/30/x2
6/30/x5
Same J.E. as recorded on 6/30/x2
12/31/x5
Same J.E. as recorded on 6/30/x2
6/30/x6
Same J.E. as recorded on 6/30/x2
12/31/x6
Same J.E. as
recorded on 6/30/x2
Long-Term Liabilities
55
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
12/31/x6 Interest Expense 5,736
Cash
5,000
Discount on Bonds Payable 735.95
1/1/x7 B/P
100,000
Cash
100,000
Discount on Bonds
1/1/x2 7,359.50
Interest Expense from
1/1/x2 to 12/31/x6
735.95 6/30/x2 = $ 5,735.95 * 10
735.95 12/31/x2 = $5,7,359.50
735.95 6/30/x3 = $50,000 + 7,359.5
735.95 12/31/x6 Interest
Discount on
payments Bonds
Long-Term Liabilities
56
Accounting for Bonds Payable -
Bonds
Are Issued at A Discount (Contd.)




J.E. for bonds issued at a discount and use the
effective interest method to amortize the
discount: using the example on p.48.
Interest Payment = $100,000 * 5%= $5,000
Interest Expense = P.V. of Bond at the
Beginning of the period  Effective Rate
Amortized Discount = Interest Expense Interest payment
Long-Term Liabilities
57
Effective Interest Amortization Tablebond are issued at a discount
1
Period
P.V at Beg.
Of Period
0
1
2
3
4
5
6
7
8
9
10
92,641
93,199
93,791
94,418
95,083
95,787
96,534
97,326
98,166
99,056
Total
2
Interest
Expense
(1) * 6%
$5,558
5,592
5,627
5,665
5,704
5,747
5,792
5,840
5,890
5,944
3
4
Cash
Amortized
(Interst)
Discount
payments (2) - (3)
$5,000
$558
$5,000
592
$5,000
627
$5,000
665
$5,000
704
$5,000
747
$5,000
792
$5,000
840
$5,000
890
$5,000
944
$57,359
$50,000
5
Unamortized
Discount
(5)-(4)
$7,359
$6,801
6,209
5,582
4,917
4,213
3,466
2,674
1,834
944
-
6
B.V. at end of
Period
$100,000 - (5)
$92,641
93,199
93,791
94,418
95,083
95,787
96,514
97,326
98,166
99,056
100,000
7,359
Long-Term Liabilities
58
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
J.E :
1/1/x2 Cash
Discount on B/P
B/P
6/30/x2 Interest Expense
(period 1)
Cash
Discount on B/P
12/31/x2 Interest Expense
(period 2)
Cash
Discount on B/P

92,641
7,359
100,000
5,558
5,000
558
5,592
5,000
592
Long-Term Liabilities
59
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
6/30/x3 Interest Expense
Cash
Discount on B/ P
:
:
6/30/x6 Interest Expense
Cash
Discount on B/P
12/31/x6 Interest Expense
Cash
Discount on B/P
1/1/x7 B/P
Cash
Long-Term Liabilities
5,672
5,000
672
5,890
5,000
890
5,944
5,000
944
100,000
100,000
60
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
Discount on Bonds Payable Interest Expense over 10
1/1/x2 7,359
558…6/30/x2
periods =>
Period 1 $5,558
592…12/31/x2 Period 2 $5,592
672…6/30/x3 period 3 $5,627
890…6/30/x6
Period 9 $ 5,890
Period 10 $ 5,944
944…12/31/x6
0
$57,359
$57360= $50,000 + 7,359
Long-Term Liabilities
61
Accounting for Bonds Payable (Contd.)


APB Opinion 21 requires the use of the
effective interest method for the
amortization of premium or discount when
two amortization methods generate
significant different result.
APB opinion 21 also requires the separate
recording of premiums and discounts.
Long-Term Liabilities
62
Book Value vs. Present Value of
Bonds



Present Value (PV) of a bond =
PV of face + PV of interest payments
All PVs are discounted at the effective
interest rate, not at the stated interest rate.
Book value (BV) of a bond =
Face amount ($) - Unamortized discount (or
+ unamortized premium).
Long-Term Liabilities
63
Book Value vs. Present Value of
Bonds


The effective interest method assuming a
constant effective interest rate (i.e., 6% in
example 2) over the life of the bond
When the effective interest method is
used to amortize the discount , the BV of
bonds equals the PV of bonds calculated
using the historical effective interest rate
(i.e., 6% as in example 2) .
Long-Term Liabilities
64
Historical Effective Interest vs.
Current Effective Interest


However, the effective interest rate is
usually changing from period to period
during the life of a bond.
The effective interest rate would
change when the factors underlying this
interest rate changed (i.e., the market
interest rate, the risk of the issuer, etc.).
Long-Term Liabilities
65
The Fair Value Option for Bonds –
SFAS No. 159



As a result, the book value of bonds, very
often, does not equal the present value of
bonds using the current effective interest
rate (referred to as the fair value).
Fair value of bonds: the present value of
bonds calculated using the current, not the
historical, effective interest rate.
SFAS 159 allows companies to have the
option to report the fair value of the bond on
the balance sheet.
Long-Term Liabilities
66
The Fair Value Option (Contd.)



This option is referred to as the fair value
option for bonds payable.
The difference between the fair value of
bonds and the book value (i.e., the
present value under the historical rate) is
calculated at the end of each period .
This difference is reported as losses (i.e.,
fair value > book value) or gains (i.e., fair
value < book value) in the income
statement.
Long-Term Liabilities
67
SFAS 159


The fair value option for financial assets
and liabilities is to provide an option of
reporting financial assets (i.e.,
investments in securities) and financial
liabilities (i.e., bonds payable) at fair
value.
The fair value option for financial liabilities
is an optional reporting method.
Long-Term Liabilities
68
SFAS 159 (contd.)


This reporting method can only be
adopted at the issuance (origination) of
a bond (loan).
Once the fair value option is chosen, no
change to other reporting method is
allowed (i.e., fair value option is an
irrevocable decision).
Long-Term Liabilities
69
SFAS 159 (contd.)


Companies can choose the fair value
option for one, a few or all of their
financial liabilities.
Pension and lease liabilities are
excluded from the fair value option.
Long-Term Liabilities
70
Fair Value Measurement (SFAS 157)
1.Quoted market prices in active markets
for identical assets or liabilities (i.e., the
market price of investments in equity
securities), or
2. Quoted prices for similar assets or
liabilities in markets (i.e., quoted market
prices for similar buildings), or
Long-Term Liabilities
71
Fair Value Measurement (contd.)
3. Applying the assumptions which market
participants would also use in pricing the
assets or liabilities (i.e., applying a current
effective interest to derive the present
value of a bond).
Note that when using this method to
estimate the fair value, the impact of the fair
value option on earnings should be
disclosed. Source: supplement of Fair Value Option of
Spiceland, etc. textbook
Long-Term Liabilities
72
The Fair Value Option – An Example
•
Using Example 2 on p48 (i.e., issued a 5-year
term bond on 1/1/x2 with $100,000 face value, 5%
stated interest , 6% effective interest and int. are
paid on 6/30 and 12/31) ,the present value
equals $92,641 on 1/1/x2 using 6% as the
discount rate. The book value under the
effective interest method (to amortize the
discount) equals $93,199 on 6/30/x2 (see
p58).
Note: $93,199=92,641 + 558 amor. Discount. $93,199 is also
the present value of the bond on 6/30 under 6% discount
rate.
Long-Term Liabilities
73
The Fair Value Option – An Example
(Contd.)
Assumed that the effective interest rate on
6/30 reduced to 5.5% due to the decline in
the primary interest rate, the present value of
the bond on 6/30 using 5.5% discount rate is
(i.e., the fair value of bonds on 6/30/x2:
PV of Principal = $100,000 x 0.6176=61,760
PV of int.
= $5,000 x 6.9522 =34,761
Sum
$96,521
Note: PV is calculated using 5.5% discount
rate (not 6%) and 9 periods (not 10 periods).

Long-Term Liabilities
74
The Fair Value Option – An Example
(Contd.)
The difference between the present value
and the book value of the bond on 6/30 =
$96,521 - $93,199 = $3,322
Journal Entry to Apply the Fair Value reporting
for the bond:
6/30 Unrealized holding loss
3,322
Fair Value Adjustment
3,322

Long-Term Liabilities
75
The Fair Value Option – An Example
(Contd.)
The reporting value of the bond under the
fair value reporting option on 6/30/x2 =
The face $ of bonds
= $100,000
The unamort. Discount =
( 6,801)
the book value prior to
fair value adjustment
$ 93,199
Fair value adjustment
3,322
The book value after
the fair value adjustment
$ 96,521

Long-Term Liabilities
76
The Fair Value Option – An Example
(Contd.)

The reported value (referred to as the
carrying value) of the bond after the fair
value adjustment , $96,521, is also the
fair value of the bond using the current
effective interest rate, 5.5% (see p76).
Long-Term Liabilities
77
Accounting for Bonds Payable -Bonds Are
Issued at A Premium
Information of example 3 is summarized with some
additional information:
 Stated Interest Rate (annual) = 10%
 Effective Interest Rate (annual) = 8%
 Date of Issuance = 1/1/x2 (sold on 1/1/x2)
 Date of Maturity = 1/1/x7
 Interest Payment Date = 6/30 and 12/31
 Face Value = $100,000
 P.V. of the Bond = $108,115 (as computed earlier)
Long-Term Liabilities
78
Accounting for Bonds Payable-Bonds Are
Issued at A Premium



Premium = $108,114.5 - 100,000 = $8,114.5
The premium would decrease the interest expense
and should be amortized over the life (5 years, 10
periods) of the bond.
J.E. (Amortization Method= Straight-Line)
$8,114.5 / 10 = $8114.5 => $811.45 would be
amortized for every period. The interest expense
would be decreased by $816 every period.
1/1/x2 Cash
108,114.5
B/P
100,000
Premium on Bonds Payable
8,114.5
Long-Term Liabilities
79
Accounting for Bonds Payable -Bonds Are
Issued at A Premium
6/30/x2 Premium on Bonds Payable
Interest Expense
Cash
12/31/x2 Premium on Bonds Payable
Interest Expense
Cash
:
:
6/30/x6 Premium on Bonds Payable
Interest Expense
Cash
Long-Term Liabilities
811.45
4,188.55
5,000
811.45
4,188.55
5,000
811.45
4,188.55
5,000
80
Accounting for Bonds Payable -Bonds Are
Issued at A Premium
12/31/x6 Premium on Bonds Payable
Interest Expense
Cash
1/1/x7 B/P
Cash
Premium on Bonds
6/30/x2 811.45 8114.5---1/1/x2
12/31/x2 811.45
.
811.45
4,188.55
5,000
100,000
100,000
Interest Expense for 10
periods = $4188.55 x 10 =
41,885.5
41,885.5 = 50,000 - 8,114.5
.
6/30/x6 811.45
Total Interest (cash) payment
12/31/x6 811.45
Premium on Discount
0
Long-Term Liabilities
81
Effective Interest Amortization Tablebond are issued at a premium
Period
0
1
2
3
4
5
6
7
8
9
10
Total
1
2
P.V. at Beg
of Period
Interst
Expense
(1) * 4%
108,114.50
107,440
106,738
106,008
103,248
104,458
103,636
102,781
101,892
100,965
4,325
4,298
4,270
4,240
4,210
4,178
4,145
4,111
4,076
4,039
41,885.50
3
Cash
Payments
100,000 x
5%
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
50,000
4
5
6
Amortizatied Unamortized P.V. at End
Premium
Premium
100,000 /
(3) - (2)
(5) - (4)
(5)
675
702
730
760
790
822
855
889
924
968*
8114.5
Interest Expense = Cash payment - Amortized premium
= 50,000 - 8114.5
= 41,885.5
* Rounding Error of $ 7 (968-961 = 7) Long-Term Liabilities
8,114.50
7,440
6,738
6,008
5,248
4,458
3,616
2,781
,892
968
0
108114.5
107,440
106,738
106,008
108,248
104,458
103,636
102,781
101,892
100,968
100,000
82
Accounting for Bonds Payable -Bonds Are
Issued at A Premium (Effective Interest Method)
J.E 1/1/x2 Cash
108,114.5
B/P
100,000
Premium on Bonds Payable 8114.5
6/30/x2
Interest Expense
4,325
(Period 1) Premium on Bonds Payable 675
Cash
5,000
12/31/x2 Interest Expense
4,298
(period 2) Premium on Bonds Payable 702
:
Cash
5,000
:
6/30/x3
Period3
Long-Term Liabilities
83
Accounting for Bonds Payable (Contd.)
(period 9)
6/30/x6
Interest Expense
Premium on B/P
Cash
12/31/x6 Interest Expense
Premium on B/P
Cash
1/1/x7
B/P
Cash
(Retirement of Bonds at Maturity)
Long-Term Liabilities
4,076
924
5,000
4,032
968
5,000
100,000
100,000
84
Accounting for Bonds Payable (Contd.)
Premium on Bonds
6/30/x2…
675
12/31/x2 …
702
730
8114.5 …1/1/x2
Interest Expense over
10 periods =>
Period
$
760
1
4,325
790
2
4,298
822
4,270
855
889
924
10
968
41,885.50
0
Long-Term Liabilities
85
Bond Retirements Before Maturity

Use example 2 (see p48), assume that bonds are
retired at the end of period 3 for $98,000
Discount on Bonds
7,359
558…..Period 1
592…..Period 2
627…..Period 3
5,582
Unamortized at the end of period 3
BV of the Bond = 100,000 - 5,582 = 94,418
Long-Term Liabilities
86
Bond Retirements Before Maturity (contd.)
B/P
100,000
Loss on Retirement of Bonds
3,582
Discount on Bonds Payable
Cash
5,582
98,000
Long-Term Liabilities
87
Bond Retirements Before Maturity (contd.)

Use example 2, assume that bonds are retired
on 10/1/x3 (half way through the 4th period) at
97 plus accrued interest of $2,500.
Discount on B/P
7,359
558
592
627
Amortized Dis. For period 4
(6 month)
3 months (665/2)
bal. 5,249.5
Long-Term Liabilities
88
Bond Retirements Before Maturity (contd.)
9/30/x3
Interest Expense
2,832.5*
Interest Payable
2,500
Discount on B/P
332.5
* Interest of period 4 (see p.55 Amort. Table) $5,665/2
10/1/x3
B/P
Interest Payable
loss
Cash
Dis on B/P
100,000
2,500
2,249.5
99,500
5,249.5
Long-Term Liabilities
89
Other Types of Debt Extinguishment: (skip p9092)


Defeasance of Debt: the debtor is legally
released from being the primary debtor of
the debt either by law or by the creditor
(i.e., the affiliate agrees to become the
primary debtor for the debt).
Accounting treatment: the liability is
removed from the B/S.
Long-Term Liabilities
90
Other Types of Debt Extinguishment (contd.):


In-substance defeasance: the debtor
places cash or other assets in an
irrevocable trust to be used for satisfying
a specific debt.
If the trust satisfies the following
conditions, the FASB allows the company
to remove the liability from its B/S:
Long-Term Liabilities
91
Other Types of Debt Extinguishment:(Contd.)
1.Trust is restricted to monetary assets that
are risk free to the amount, the timing and
collection of interests and principal.
2.The monetary assets must provide cash
flows that are similar to the timing and the
amount of the scheduled interests and
principal payments on the debt being
extinguished.
Long-Term Liabilities
92
Accounting for Bonds Sold Between
Interest Payment Dates:

Policy of interest payment for bonds:
Interest
are always paid in full
regardless how long the bonds being
held by the bondholder.
Thus,
the bond issuing company
collects the accrued interests in
addition to the issuing price when
bonds are sold between interest
payment dates.
Long-Term Liabilities
93
Accounting for Bonds sold Between
Interest Payment Dates at Par:

Example: On 2/1/x2, Page company
issued a 5-year term bond with a face
amount of $100,000 and a stated interest
rate of 10%. The bonds were sold on
5/1/x2 at par and interests were paid
semiannually on 2/1 and 8/1.
Long-Term Liabilities
94
Accounting for Bonds Sold Between
Interest Payment Dates at Par:

J.E. 5/1/x2 (bond sold at par on 5/1/x2)
Cash
Bonds Payable
Interest Payable*
102,500
100,000
2,500
* Accrued interest of 3 months (From 2/1 ~ 5/1)
8/1/x2 Interest Payable*
Interest Expense
Cash
2,500
2,500
* 100,000 x 10% x 6/12 = 5,000 (6 month interest)
Interest Expense from 5/1/x2 - 8/1/x2 =>
5,000 -2,500 = 2,500
Long-Term Liabilities
5,000
95
Debt Sold Between Interest Payment Dates at A
Discount


Green Company issued a two-year, 8%
term bonds with a maturity value of
$200,000. The bonds are dated 1/1/x2 and
pay $8,000 interest semiannually on 7/1
and 12/31.
They are sold on 3/1/x2 for $196,123,
which includes $2,667 accrued interest from
1/1/x2 to 3/1/x2 to yield 5% interest
semiannually.
Long-Term Liabilities
96
Debt Sold Between Interest Payment Dates at A
Discount or A Premium (Contd.)
Present value at 1/1/x2 based on
semiannual yield of 5% =>
P.V. of the principle 200,000 x .8227 = 164,540
P.V. of Interest
8,000 x 3.5460 = 28,368
P.V. on 1/1/x2
$192,908
Long-Term Liabilities
97
Debt Sold Between Interest Payment Dates At A
Discount or A Premium (Contd.)
The P.V. of the bonds on 3/1/x2 =>
(PV0 + Dis. Amortized for 2 months) =>
Dis. Amortized for 1/1/x2 to 6/30/x2 = 192,908x 0.05
– 8,000 = $1,645.
PV on 3/1/x2 = $192,908 + 1,645 x 2/6
= 192,908 + 548
= 193,456
 Accrued interest from 1/1/x2 to 3/1/x2:
= 200,000 x 4% x 2/6=2,667

Long-Term Liabilities
98
Debt Sold Between Interest Payment Dates At A
Discount or A Premium (Contd.)

Therefore, the selling price on 3/1/x2 =>
193,456 + 2,667 = $196,123 (including
the 2-month accrued interest)
* See the schedule on p 101
Long-Term Liabilities
99
Debt Sold Between Interest Payment Dates At A
Discount or A Premium (Contd.)

J.E. on 3/1/x2
Cash
196,123
Dis. On B/P
6,544**
B/P
200,000
Interest Payable
2,667
** (200,000 - 193,456) or (200,000 - 192,908) - 548
Long-Term Liabilities
100
Debt Sold Between Interest Payment Dates At A
Discount or A Premium (Contd.)

Schedule of Interest & B.V
6 Months Interest
Ending Expense
Cash
1/1/x2
7/1/x2
12/31/x2
7/1/x3
12/31/x3
8,000
8,000
8,000
8,000
9,645*
9,728
9,814
9,905
Discount
Amortize
d
1,645**
1,728
1,814
1,905
B.V
192,908
194,553
196,281
198,095
20,000
* 192,908 x 0.05 = 9,645 in which $3,215 (9,645 x 2/6)
was for the period of 1/1/x2 - 3/1/x2
** 9,645 - 8,000 =1,645 in which $548 was for period of
1/1/x2 - 3/1/x2
Long-Term Liabilities
101
Debt Sold Between Interest Payment Dates At A
Discount or A Premium (Contd.)
7/1/x2
Interest Expense
Interest Payable
Discount on B/P
Cash
6,4301
2,6672
1,097
8,000
1. 9,645 x 4/6= 6,430
2. 1,645 x 4/6 = 1,097
12/31/x2 Interest Expense
Cash
Discount on B/P
Long-Term Liabilities
9,728
8,000
1,728
102
Debt Sold Between Interest Payment Dates At A
Discount or A Premium (Contd.)
7/1/x3
Interest Expense
9,814
Cash
Discount on B/P
8,000
1,814
12/31/x3 Interest Expense
9,905
Cash
Discount on B/P
8,000
1,905
Discount on B/P
6,544
1,097
1,728
1,814
1,905
0
Long-Term Liabilities
103
Accruing Bond Interest
Assumed that Page Company issued a 5year term bond with a face amount of
$100,000 and a stated interest of 10% on
10/1/x2. The bonds were sold on 10/1/x2
and interest were paid semiannually (on 10/1
and 4/1). The effective interest rate is 12%.
Therefore, the present value of the bonds is
$92,640.5.
J.E 10/1/x2 Cash
92,640.50
Discount
7,359.50
B/P
100,000

Long-Term Liabilities
104
Accruing Bond Interest (contd.)
12/31/x2 (adjusting entry for accrued interest expense)
(Straight -line method)
Interest Expense
2,858
Interest Payable
2,500
Discount on B/P*
368
7,359.50 / 5 x 3/12 = 368 (straight-line method)
12/31/x2 (Effective interest method)
Interest Expense*
2,779
Interest Payable
Discount on B/P
* Effective Interest of 3 months:
92,640.50 x (12% x 1/2)Long-Term
x 3/6Liabilities
= 2,779
2,500
279
105
Accruing Bond Interest (contd.)
Effective Interest Method:
4/1/x3 Interest Expense
2,779
Interest Payable
2,500
Cash
Discount on B/P
5,000
279
10/1/x3 Interest Expense
5,591.91*
Cash
5,000
Discount on B/P
591.91
*(92,640.5+279+279) * 0.06 = 5,591.91
Long-Term Liabilities
106
Bonds Issued with Detachable
Stock Warrants (Stock Rights)


Stock warrants represent rights that
enable the security holder to acquire a
specific number of common stock at a
given price within a certain time period.
Stock warrants are attached to bonds to
increase their marketability
Long-Term Liabilities
107
Bonds Issued with Detachable Stock
Warrants (Stock Rights) (contd.)


These detachable warrants can be sold
separately from the bonds in the open
market within a short time of issue.
APB Opinion 14 requires that a portion
of the proceeds from bonds issued with
detachable warrants be allocated to the
stock warrants and accounted for as
additional paid-in capital.
Long-Term Liabilities
108
Bonds Issued with Detachable Stock
Warrants (Stock Rights) (contd.)


The allocation is based on the relative
market values of the bonds and
warrants if the market values of bonds
and warrants are both available.
If only the market value (MV) of
warrants is available, the MV of the
warrants will be the amount allocated
as the value of warrants.
Long-Term Liabilities
109
Example



Paul Company sold $800,000 of 12%
bonds at 101.
Each $1,000 bond carried 10 warrants,
and each warrant allowed the holder to
acquire one share of $5 par common
stock for $25 per share.
After issuance, the bonds were quoted at
99 ex rights (without the right attached)
and the warrants were quoted at $3 each.
Long-Term Liabilities
110
Example (contd.)


Value Assigned to Bonds
$990  800
= ----------------------------------------  $808,000
$990  800 + ($3  800  10)
= $784,235.29
Value Assigned to Warrants (right)
$3  800  10
= ----------------------------------------  $808,000
$990  800 + ($3  800  10)
= $23,764.71
Long-Term Liabilities
111
Example (contd.)
* Bonds with the same risk can only be issued
at 99 (rather than 101) without warrants
J.E Cash
808,000
Discount on B/P
15,764.71
B/P
800,000
Comm. Stock Warrants
23,764.71
* $800,000 -784,235.29 = 15,764.71
Long-Term Liabilities
112
Example (contd.)
$23,764.71
Value of One Warrant =----------------- = $2.971
10  800
If 500 of the warrants were exercised at the $25
per share exercise price, the entry is:
Cash
Common Stock Warrants
Common Stock
Additional Paid-in
Capital on C.S
1. $25 x 500
3. 5 x 500
12,500 1
1,485.50 2
2,500 3
11,485.50 4
2. 2.971 x 500
4. (12,500 + 1485.50) - 2,500
Long-Term Liabilities
113
Example (contd.)
If the remaining warrants expire, the
following entry would be made:
Common Stock Warrants 22,279.21 1
Additional Paid-in Capital
From Expired Warrants
22,279.21
1. 23,764.71 -1,485.50
Long-Term Liabilities
114
Convertible Bonds


Bonds that may be converted into
common stock at a specified price at the
option of the holder.
At issuance, the conversion price is
usually greater than the market value of
common stock.
Long-Term Liabilities
115
Convertible Bonds (Contd.)


Convertible bonds are often issued
with call option for the issuer.
The issuer can force conversion by
exercising its call option when share
price has risen sufficiently in the future.
Long-Term Liabilities
116
Convertible Bonds (contd.)
Reasons of issuing convertible
bonds:
1. As an indirect way to issue stock
when facing resistance from current
stockholders to issue additional
stock;
2. To issue bonds at a higher price
(thus, lower effective interest rate);

Long-Term Liabilities
117
Convertible Bonds (contd.)
3. Avoid the downward price pressure on
its stock;
4. Avoid the direct sale of its stock when
the company believes its stock
currently is undervalued.
Long-Term Liabilities
118
Accounting Treatment for
Convertible Bonds

APB Opinion 14 requires that the
issuance of convertible debt is
recorded in the same manner as the
issuance of nonconvertible debts
without allocating a value (from the
proceeds received) to the conversion
feature. (Reason?)
Long-Term Liabilities
119
Recording for the Conversion
Two acceptable methods:
A. Book Value Method: the stockholders’
equity is recorded at the book value of the
convertible bonds on the date of conversion.
 No gain or loss is recorded upon
conversion.
 If the par value of the common stock is
greater than the book value of the bonds,
the difference is recorded as a reduction
of retained earnings.
Long-Term Liabilities
120
Recording for the Conversion
(contd.)
B. Market Value Method: The
stockholders’ equity is recorded at the
market value of the shares issued on
the date of conversion, and a gain or
loss is recorded (treated as an ordinary
income or loss).
Long-Term Liabilities
121
Recording for the Conversion
(contd.)
B. (continued)
The gain or loss is the difference
between the market value of the
converted common stock and the book
value of the bonds.
If the conversion occurs between
interest dates, the interest expense
needs to be recorded and amortization
of discount or premium also needs to
be recognized to update the book
value of the bonds.Long-Term Liabilities

122
Example

Shannon Company has outstanding
convertible bonds with a face value of
$10,000, interest has been paid on these
bonds, and the bonds have a book value
of $10,500.
Each $1,000 bond is convertible into 40
shares of common stock (par value $20
per share).
Long-Term Liabilities
123
Example (contd.)

If all the bonds were converted into
common stock when the market value
of Shannon’s common stock is $26.5
per share, the following alternative
entries may be made:
Long-Term Liabilities
124
Example (contd.)
A. Book Value Method: (BV of the bonds=
$10,500) (more commonly used by companies)
Bonds payable
10,000
Premium on Bonds Payable
500
Common Stock 1
8,000
Paid-in Capital from
Bond Conversion 2
2,500
1. $20 x 40 x 10
2. 10,500 - 8,000
Long-Term Liabilities
125
Example (contd.)
B. Market Value Method : (MV of converted
Stock = 26.5 x (40x 10) = 10,600)
Bonds payable
10,000
Premium on B/P
500
Loss on Conversion
100
Common Stock
8,000
Paid-in Capital from
Bond Conversion
2,600 1
1. 10,600 - 8,000
Long-Term Liabilities
126
Induced Conversions


A Company may sweeten the
conversion feature to induce the
conversion of bonds to common stock
in order to reduce interest costs.
The additional cost is recognized as an
expense.
Long-Term Liabilities
127
Example

Harmon Company had issued
convertible bonds at par.The
conversion terms allowed each $1,000
bond to be converted into 40 shares of
common stock (par value $21 per
share).
Harmon induces the conversion terms
to 50 shares if conversion is made in 60
days.
Long-Term Liabilities
128
Example (contd.)
All bonds were converted within the
time limit when the market price of the
common stock is $30 per share.
At the time of conversion, the book
value of the bonds is $10,000.
Long-Term Liabilities
129
Example (contd.)
Using the book value method, the following
entry will be recorded:
Bonds Payable
10,000
Bond Conversion Expense 3,000
Common Stock
($ 21 x 50 x 10)
10,500
Paid-in Capital in Excess *
of Par Value
2,500
*13,000 - 10,500
Long-Term Liabilities
130
Example (contd.)
If the market value method is used, the
following entry will be recorded:
B/P
10,000
Bond Conversion Expense 3,000
Loss on Conversion
2,000
Common Stock ($21 x 50 x 10) 10,500
Paid-in capital in Excess of Par
4,500
Long-Term Liabilities
131
Long-Term Notes Payable


APB Opinion No. 21 requires the longterm notes payable to be recorded at
their present values.
When notes are exchanged for cash,
the cash received is considered the
present value of the note.
Long-Term Liabilities
132
Long-Term Notes Payable (contd.)


The effective interest rate (or the
implicit rate) is the rate that equates the
future net cash flows to the present
value.
The effective interest can be derived
when the present value and future net
cash flows are known.
Long-Term Liabilities
133
Long-Term Notes Payable (contd.)

In cases when the present value is
unknown, the incremental interest rate
of the borrower would be used as the
effective rate to calculate the present
value of the note.
Long-Term Liabilities
134
Long-Term Notes Payable (contd.)
A. Notes payable issued for cash:
When a long-term note is exchanged for
cash, the note is assumed to have a
present value equals the cash proceeds.
The difference between the cash
proceeds and the face value of the note
is recorded as a discount (or premium)
The discount (or premium) is amortized
over the life of the note using the effective
interest method.
Long-Term Liabilities
135
Example

Johnson Company issued a 3-year, noninterest-bearing note with a face value of
$8,000 and received $5,694.24 in exchange.
The journal entry to record the issuance is:
Cash
Discount on
Notes Payable
Note Payable
5,694.24
2,305.76
8,000
Long-Term Liabilities
136
Example (contd.)

The discount account is a contra account to
notes payable. The effective interest rate
that equates the P.V. of 5,694.24 to $8,000
at the end of 3 years is 12%.
5,694.24 = 8,000 x 0.71178  3-period, 12%
Long-Term Liabilities
137
Example (contd.)
The Interest Expense Per Year is Computed as:
N/P
Less:
Unamortized
Discount
Carrying Value
(at beg.)
x Effective Rate
Interest
Expense
- Interest
Payment
Amortized
Discount
Year 1
8,000
Year 2
8,000
Year 3
8,000
(2,305.76)
(1,622.45)
(857.14)
5,694.24
6,377.55
7,142.86
12%
12%
12%
683.31
765.31
857.14
0
0
0
683.31
765.31
857.14
Long-Term Liabilities
138
Example (contd.)
Recognition of Interest Expense of Year 1:
Interest Expense
683.31
Discount on N/P
683.31
Cash
(non-interest bearing note)
Long-Term Liabilities
0
139
Notes Payable Exchanged for Cash AND
Rights or Privileges (skip p139-144)

A company might sign a contract with
a customer in which the company
borrows cash from the customer on a
non-interest-bearing basis,
with the understanding that the
customer has the right to purchase
certain goods from the company at
less than prevailing market price over
the period of the contract.
Long-Term Liabilities
140
Example



Verna Company borrows $100,000 by
issuing a 3-year, non-interest-bearing
note to a customer.
Verna agrees to sell inventory to the
customer at reduced prices over a 5-year
period.
Verna’s incremental borrowing rate is
12% so that the P.V. of $100,000 to be
repaid at the end of 3 years is $71,178.
.
Long-Term Liabilities
141
Example (contd.)

The customer agrees to purchase an
equal amount of inventory each year over
the 5-year period so that a straight line
method of revenue recognition is
appropriate.
Long-Term Liabilities
142
Example (contd.)
The following entries are recorded during the first
two years:
At the issuance of the Note
Cash
100,000
Discount on N/P
28,822
N/P
100,000
Unearned revenue
28,822
Long-Term Liabilities
143
Example (contd.)
End of first Year
Interest Exp. (71,178 x 12%)
8,541.36
Discount on N/P
8,541.36
Unearned Revenue (28,822/5) 5,764.40
Sales Revenue
5,764.40
End of Second Year
Interest Exp.
((76,178 + 8,541.36) x 12%)
Discount on N/P
Unearned Revenue
Sales Revenue
9,566.32
9,564.40
5,764.40
Long-Term Liabilities
5,764.40
144
Notes Payable Exchanged for Cash
AND Rights or Privileges (contd.)
Therefore, the accounting treatment is:
1. The note is recorded at the P.V. of the note at
the time of issuance.
2. The difference between the cash proceeds
(i.e., $100,000) and the P.V. of the note is
recorded as unearned revenue ($100,000 71,178), and revenue is recognized over the life
of the contract using an appropriated revenue
recognition method.
3. The discount of the note is amortized over the
life of the note using the effective interest
method.
Long-Term Liabilities
145
Notes Exchanged for Property,
Goods, or Services


APB 21 requires the note be recorded
at the fair market value of the property,
goods, or services or the fair value of
the note, whichever is more reliable.
The effective interest rate is calculated
and used to calculate subsequent
interest expense using the effective
interest method.
Long-Term Liabilities
146
Notes Payable Exchanged for
Property, Goods, or Services (contd.)

If neither of these values is
determinable, the incremental
borrowing rate of the borrower would be
used as the effective interest rate to
calculate the present value of the note.
Long-Term Liabilities
147
Example



On 1/1/x5, Marden Company purchases
an equipment by issuing a non-interestbearing 5-year note with a face value of
$10,000.
Neither the fair market value of the
equipment nor that of the note is
determinable.
The incremental borrowing rate of Marden
is 12%.
Long-Term Liabilities
148
Example (contd.)
J.E. 1/1/x5
Equipment
Discount on N/P
5,674.27*
4,325.73
N/P
10,000
* P.V. of the note using 12% as the effective interest
rate => 10,000 x 0.567427
Long-Term Liabilities
149
Example (contd.)
12/31/x5
Int. Exp. (5674.27 x 12%)
680.91
Discount on N/P
680.91
Depreciation Expense
567.43
Accumulated Depreciation
567.43
(Assuming a S-L depreciation method is used
and a 10-year life is assumed for the
equipment)
Long-Term Liabilities
150
Example (contd.)
12/31/x6
Int. Exp. (5,674.27 + 680.91) x 12%
762,62
Discount on N/P
762.62
Depreciation Expense
567.43
Accumulated Depreciation
Long-Term Liabilities
567.43
151
Example (contd.)

Using the previous example, except
that the fair market value the equipment
was determined at $6,209.21. The
interest rate that equates the future
cash flows to the present value of
$6,209.21 is 10%.
Long-Term Liabilities
152
Example (contd.)
The following entries would be recorded for
20x5 and 20x6:
1/1/x5
Equipment
6,209.21
Discount on N/P
3,790.89
N/P
10,000
12/31/x5
Int. Exp. (6,209.21 x 10%)
621
Discount on N/P
621
12/31/x6
Int. Exp. (6,209.21 + 621) x 10% 683
Discount on N/P
683

Long-Term Liabilities
153
Installment Notes


Notes could be paid by installments
rather than by a single amount at
maturity.
Using the above example on page 151,
assuming an installment payment at the
end of each year for the following 5
years, ( starting 12/31/x5), the annual
installment payment for the note (loan)
equals:
$6,209.21/ 3.79079=$1,638
Long-Term Liabilities
154
Installment Notes: (Contd.)

Journal Entries:
1/1/x5
Equipment
6,209.21
Note Payable
6,209.21
12/31/x5 Interest Exp. * 621
N/P
1,017
Cash
1,638
*6,209.21 x 10% = 621
12/31/x6 Interest Exp. * 519
N/P
1,119
Cash
1,638
*(6,209.21 - 1,017) x 10% = 519.2
Long-Term Liabilities
155
Installment Notes: (Contd.)

Journal Entries:
12/31/x7 Interest Exp. * 407
N/P
1,231
Cash
1,638
*(6,209-1,017-1,119) x 10% = 407
12/31/x8 Interest Exp. * 284
N/P
1,354
Cash
1,638
*(6,209-1,017-1,119-1,231) x 10% = 284
12/31/x9 Interest Exp. * 149
N/P
1,489
Cash
1,638
*(6,209-1,017-1,119-1,231-Long-Term
1,354)
x10%
=
149
Liabilities
156
Installment Notes: (Contd.)
N/P
1017
6209
1119
1231
1354
1489
0*
rounding error = $1
Long-Term Liabilities
157
Installment Notes: (Contd.)


An installment note typically is recorded
at its carrying amount (i.e., the face
amount - the unamortized discount).
This is because the outstanding
balance of an installment does not
become its face amount as in the case
for notes with a single payment at
maturity.
Long-Term Liabilities
158
Long-term Notes Receivable (skip
p158-170)


If a long-term note received from selling
property, goods, providing service, the
note is recorded at the fair market value
of the property goods, or services or the
fair market value of the note (the present
value if known), whichever is more
reliable.
An effective interest rate will then be
derived and used to amortized the
discounts or premiums.
Long-Term Liabilities
159
Long-term Notes Receivable
(contd.)


If neither of these values is reliable, the
note is recorded at its present value by
using the borrower’s incremental
interest rate (as the effective interest
rate).
The effective interest method is used to
record subsequent interest revenue.
Long-Term Liabilities
160
Example

Joyce Company accepted a $10,000, noninterest-bearing, 5 year note on 1/1/x5 in
exchange for an equipment sold to Marden
Company. Since a reliable fair market value of
the equipment or the note was not available,
Marden’s (the borrower) 12% incremental
borrowing rate was used to determine the
P.V. of $5,674.27 for the note. The cost of the
equipment is $8,000 and the book value is
$5,000 on the date of sale.
Long-Term Liabilities
161
Example (contd.)
The following entries will be recorded for Joyce:
1/1/x5
Notes Receivable
10,000
Accumulated Depreciation
3,000 2
Discount on N/R 1
4,325.73
Equipment
8,000
Gain on Sale of Equipment 3
674.27
1. 100,000 -5,674.27
2. 8,000 - 5,000 (B.V.)
3. P.V. of the Note - B.V. of the Equipment
= 5,674.27 - 5,000
Long-Term Liabilities
162
Example (contd.)
12/31/x5
Discount on N/R 1
Interest Revenue
680.91
680.91
1. 5,674.27 x 12%
P.V. of Note on 1/1/95
12/31/x6
Discount on N/R 1
Interest Revenue
762.62
762.62
1. (5,674.27 + 680.92) x 12%
Long-Term Liabilities
163
Impairment of A Loan (FASB 114)


A loan (note receivable) is impaired if it is
probable that the creditor will be unable to
collect all amounts due according to the
(contractual) terms of the loan agreement.
When a loan is found to be impaired, the
creditor company (often a financial
institution) computes the present value of
the expected future cash flows of the
impaired loan using the original effective
interest rate on the loan.
Long-Term Liabilities
164
Impairment of Loan (FASB 114)
(contd.)

The amount by which the present value is
less than the recorded investment in the
loan is recognized as Bad Debt Expense
and Allowance for Doubtful Notes.
Long-Term Liabilities
165
Example

Assuming Snook Company has a 6-year note
receivable of $100,000 from the Ullman
Company on 1/1/x2 that is being carried at face
value.
The loan agreement specifies that interest of
8% is payable each 12/31 and the principal is to
be paid on 12/31/x7. The Ullman paid the
interest due on 12/31/x2, but informed the
Snook Company that it probably would have to
miss the next two year’s interest payments.
Long-Term Liabilities
166
Example
After that, it expected to resume the
$8,000 annual interest payments, but
the principal payment would be made
one year late with interest paid for the
additional year.
The present value P.V. of the impaired
loan of Snook on 12/31/x2 is:
Long-Term Liabilities
167
Example (contd.)

P.V. of Principal
= $100,000 x P.V. of a single sum for 6 years at 8%
= $100,000 x 0.630170
= $63,0170

P.V. of Interest
= $8,000 x 3.312127 x 0.857329
= $22,716.93 annuity of 4 years at 8% Defer for 2-years
Long-Term Liabilities
168
Example (contd.)

P.V. of the Impaired Loan
= 63,017 + 22,716.93
= $85,733.93

The amount of impairment
= $100,000 - 85,733.93
= $14,266.07
Long-Term Liabilities
169
Recognition of the Impairment
12/31/x2
Bad Debt Expense
14,266.07
Allowance for Doubtful Notes
14,266.07
At Dec. 31, x3, Snook recognized interest revenue of
$6,858.71:
12/31/x3
Allowance for Doubtful Notes
6,858.71*
Interest Revenue
6,858.71
* $85,733.93 x 8% = 6,858.71
the new carrying value of the impaired note
Long-Term Liabilities
170
Recognition of the Impairment
(contd.)
12/31/x2
Allowance for Doubtful Notes**
Interest Revenue
** (85,733.93 + 6,858.71) x 8%
7,407.41
Long-Term Liabilities
7,407.41
171
Troubled Debt Restructuring

When the borrower is in severe
financial difficulties, the creditor(s) may
change the terms of debt agreement
(i.e.,reduce the amount of principal or
reduce the amount of interest payments
or both.) rather than force the borrower
to liquidate.
Long-Term Liabilities
172
Troubled Debt Restructuring (Contd.)


This new agreement is referred to as a
trouble debt restructuring.
A trouble debt restructuring can be one
of the following:
1.The debt is settled at the time of
restructuring ; or
2.The debt is continued but with modified
terms.
Long-Term Liabilities
173
Troubled Debt Restructuring (Contd.)
A. Debt is Settled:

The debtor’s gain = the carry amount of
the debt - the value of the asset(s)
transferred to settle the debt.
Long-Term Liabilities
174
Troubled Debt Restructuring (Contd.)
A. Debt is Settled:

Example 1:
A bank holding a $50 million note
agrees to accept a land valued at $40
million from R.J. company, which is in
severe financial difficulties, as a
settlement of the $50 million debt.
Long-Term Liabilities
175
Troubled Debt Restructuring (Contd.)
A. Debt is Settled:

Assumed that the carrying amount of the
land is $32 million. The following journal
entries are recorded for this troubled debt
restructuring:
($ in million)
1)Land (40million-32million)
8
Gain on disposition of assets
8
2)Note Payable
50
Land(at fair value)
40
Gain on troubled debt restructuring 10
Long-Term Liabilities
176
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

In this case of troubled debt
restructuring, the bank allows the debt to
continue but modifies the terms of debt
agreement, such as:
1) reduce or delay the interest payments;
2) reduce or delay the maturing amount;
3) a combination of these concessions.
Long-Term Liabilities
177
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

Example 2:
Assuming a 10% stated interest on the $50
million note is in question and interests($50
million x 10% = 5 million) are payable in
December of the two remaining years. In
addition, R.J. failed to pay $5 million of
interest for the year just ended. Therefore,
the carrying amount of the debt is $55
million.
Long-Term Liabilities
178
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:


The accounting treatment for this type of
trouble debt restructuring depends on
the total amount of future cash
payments.
Case I : Total future cash payments <
The carrying amount of the debt
Long-Term Liabilities
179
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:
Accounting Treatment:
a)Recognize a gain (extraordinary) equals
the difference between the carrying
amount of the debt and the total future
cash payments
b)Reduce the carrying amount of the debt
to the total future cash payments by:
1) reducing the accrued interests, and
2) reducing the debt.

Long-Term Liabilities
180
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

Accounting Treatment (contd.):
C) If entire accrued interests were
eliminated, all subsequent cash
payments are payments for the
debt itself.
Long-Term Liabilities
181
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

Continued with Example 2, assuming that
the bank agrees to the following terms:
a)Eliminate the accrued interest of last year;
b)Reduce the remaining two interest payments
from $ 5 million each to $3 million each; and
c)Reduce the maturity value from $50 million
to $40 million.
Long-Term Liabilities
182
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

Extraordinary Gain:
Carrying Amount
$55 million
Future Cash Payments* $46 million
Gain
$ 9 million
* $3 million x 2+ 40 million = $46 million
Long-Term Liabilities
183
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

J.E.
($ in million)
Interest Payable
5
Note Payable**
4
Gain on debt restructuring
9
** Balance of this debt = $50-4 = $46 million=
Total future cash payments on this debt
Long-Term Liabilities
184
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:




J.E. At each of the two interest payment
dates
12/X+1
($ in million)
Note Payable
3
Cash
3
12/X+2
Note Payable
3
Cash
3
At maturity:
Note Payable
40
Cash
40
(revised principal
amount)
Long-Term Liabilities
185
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:



Case II: Total cash payments exceed the
carrying amount of the debt
Continued with example 2, assuming that
the bank agrees to delay the due date for all
cash payments until maturity date and
accept $57,222,000 at maturity date.
Since $57,222,000 exceeds the carrying
amount of the debt ($55 million), the new
agreement still require an interest payment.
Long-Term Liabilities
186
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:

A new effective interest rate needs to
be calculated as follows:
$55,000,000 / $57,221,927=0.96117
The present value table (6A-2)
indicates that the new effective interest
rate is 2%.
Long-Term Liabilities
187
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:
J.E.
1)At the debt restructuring date:no entry is
required.

2)At the end of the first year following the
restructuring:
Int. Exp.(2%x$55 million) 1,100,000
Interest Payable
1,100,000
Long-Term Liabilities
188
Troubled Debt Restructuring (Contd.)
B. Debt is Continued but with Modified Terms:
3)At the end of the second year
Interest Exp.*
1,122,000
Interest Payable
1,122,000
* 2% x ($55million + 1,100,000)
4)At maturity Date:
Note Payable
Interest Payable
Cash
50,000,000
7,222,000
57,222,000
Long-Term Liabilities
189