Chapter 14 Bonds and Long-Term Notes Long-Term Liabilities 2 Topics of Long-Term Liabilities n Issuance of bonds (at a premium or discount) n Fair value

Chapter 14

Bonds and Long-Term Notes

Long-Term Liabilities2

Topics of Long-Term Liabilities 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 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%) = $100P.V. = $100/1.1

= $100 0.9091 = $90.91


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%) = $100P.V (1+10%)2 = $100P.V. 1.21 = $100P.V. = $100 / 1.21

= $100 0.8264= $82.64


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)


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


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.


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%)


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.


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).


Bonds Payable

Long-Term Liability: if bonds mature in more than one year.

Short-Term Liability: if bonds mature in less than one year


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.

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.



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.


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.



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.



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.


The Process of Bond Issuance (Contd.)

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.


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


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


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


Types of bonds:

On the basis of how the bonds mature: Term Bonds Serial Bonds Convertible Bonds Callable Bonds

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.


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.


Bond Ratings (Source: BestVest Investments, Ltd)


Moody's

S & P Meaning

AaaAAA

Best quality, with the smallest amount of risk. Issuers are extremely stable and dependable.

Aa AAHigh quality, with a slightly higher degree of long-term risk.

A AHigh to medium quality, with many strong attributes but with some risk exposure to changing economic conditions.

Baa BBBMedium quality, currently adequate but with significant risk possible over the long term.

Bond Ratings (contd.)

Ba BBSome speculative element, with moderate security but not well safeguarded for the long haul.

B BAble to pay now but with a significant risk of default in the future.

Caa CCC Poor quality with a clear danger of default.

Ca CC High speculative nature, often in or near default.

C CLowest 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 bondmatures 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.


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.



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.



Bonds Issued at Face ValueWhen the stated interest rate equals the effective interest rate, the bond price will equal the face value.


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)?



(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 = 38,608.5annuity table, 5%, 10periods



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!!



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


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.


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


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 92,640.5Discount on Bonds 7,359.5

Bonds Payable 100,000


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


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%)


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



(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)



Example 3J.E. (When Bonds are issued at Premium)Cash 108,114.5

Bonds Payable 100,000Premium on Bonds Payable 8,114.50



Interest Expense= interest payments - Premium

= $5,000 x 10 - 8,114.5

= $41,885.5

(Premium will decrease the interest expense.)



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.



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.


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 CompanyStated Interest: 10% (annual)Effective Interest: 10% (annual)Date of Issuance: 2/1/x2Date of Maturity: 2/1/x7Interest Payment Dates: 2/1 and 8/1Face Value: $100,000P.V. of the Bond: $100,000


Accounting for Bonds Payable - Bonds Are Issued at Par (Contd.) J.E.

2/1/x2 Cash 100,000B/P 100,000

8/1/x2 Interest Expense 5,000Cash 5,000

12/31/x2Adjusting 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


Accounting for Bonds Payable - Bonds Are Issued at Par (Contd.)

(Reversing Entry)1/1/x3 Interest Payable 4,167

Interest Expense 4,1672/1/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 833Interest Payable 4,167

Cash 5,000


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


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 5,000Bonds Payable 100,000

cash 100,000(Bond Retirements at Maturity)


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)


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: $7349.5010 = $735.95Therefore, the interest expense every period is

$5,000 + 7,35.95 = $5,735.95Semiannual the amortized DiscountInterest Payment



Total Interest expense = 5,735.95 x 10 = $5,7359.5 = 50,000 + 7,359.5

Int. payment Discount

2. Effective Interest MethodInterest Expense = P.V. of Bond effective rate



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 100,0006/30/x2 Interest Expense 5,736

Cash 5000*Discount on B/P 735.95**

12/31/x2 Interest Expense 5,736Cash 5,000Discount on B/P 735.95


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/x212/31/x3 Same J.E. as recorded on 6/30/x26/30/x4 Same J.E. as recorded on 6/30/x212/31/x4 Same J.E. as recorded on 6/30/x26/30/x5 Same J.E. as recorded on 6/30/x212/31/x5 Same J.E. as recorded on 6/30/x26/30/x6 Same J.E. as recorded on 6/30/x212/31/x6 Same J.E. as recorded on 6/30/x2



12/31/x6 Interest Expense 5,736Cash 5,000Discount on Bonds Payable 735.95

1/1/x7 B/P 100,000Cash 100,000

Discount on Bonds

1/1/x2 7,359.50 735.95 6/30/x2

735.95 12/31/x2

735.95 6/30/x3

735.95 12/31/x6

Interest Expense from 1/1/x2 to 12/31/x6

= $ 5,735.95 * 10

= $5,7,359.50

= $50,000 + 7,359.5

Interest payments

Discount on Bonds



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


Effective Interest Amortization Table-bond are issued at a discount

1 2 3 4 5 6

PeriodP.V at Beg. Of Period

Interest Expense (1) * 6%

Cash (Interst)

payments

Amortized Discount (2) - (3)

Unamortized Discount

(5)-(4)

B.V. at end of Period

$100,000 - (5)

0 - - - - $7,359 $92,6411 92,641 $5,558 $5,000 $558 $6,801 93,1992 93,199 5,592 $5,000 592 6,209 93,7913 93,791 5,627 $5,000 627 5,582 94,4184 94,418 5,665 $5,000 665 4,917 95,0835 95,083 5,704 $5,000 704 4,213 95,7876 95,787 5,747 $5,000 747 3,466 96,5147 96,534 5,792 $5,000 792 2,674 97,3268 97,326 5,840 $5,000 840 1,834 98,1669 98,166 5,890 $5,000 890 944 99,05610 99,056 5,944 $5,000 944 - 100,000

Total $57,359 $50,000 7,359



J.E :1/1/x2 Cash 92,641

Discount on B/P 7,359 B/P 100,0006/30/x2 Interest Expense 5,558(period 1) Cash 5,000

Discount on B/P 55812/31/x2 Interest Expense 5,592(period 2) Cash 5,000

Discount on B/P 592



6/30/x3 Interest Expense 5,672Cash 5,000Discount on B/ P 672

::

6/30/x6 Interest Expense 5,890Cash 5,000Discount on B/P 890

12/31/x6 Interest Expense 5,944Cash 5,000Discount on B/P 944

1/1/x7 B/P 100,000Cash 100,000



Discount on Bonds Payable

1/1/x2 7,359 558…6/30/x2

592…12/31/x2

672…6/30/x3

890…6/30/x6

944…12/31/x6

0

Interest Expense over 10 periods =>

Period 1 $5,558

Period 2 $5,592

period 3 $5,627

Period 9 $ 5,890

Period 10 $ 5,944

$57,359

$57360= $50,000 + 7,359


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.

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).


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) .


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.).


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.


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.


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.


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).


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.


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


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


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).


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


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


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).



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)


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 100,000Premium on Bonds Payable 8,114.5



6/30/x2 Premium on Bonds Payable 811.45 Interest Expense 4,188.55

Cash 5,00012/31/x2 Premium on Bonds Payable 811.45

Interest Expense 4,188.55Cash 5,000

::


Cash 5,000




Cash 5,000

1/1/x7 B/P 100,000Cash

100,000Premium on Bonds

6/30/x2 811.45 8114.5---1/1/x2

12/31/x2 811.45

.

.

6/30/x6 811.45

12/31/x6 811.45

0

Interest Expense for 10 periods = $4188.55 x 10 = 41,885.5

41,885.5 = 50,000 - 8,114.5

Total Interest (cash) payment

Premium on Discount


Effective Interest Amortization Table-bond are issued at a premium

1 2 3 4 5 6

PeriodP.V. at Beg

of Period

Interst Expense (1) * 4%

Cash Payments 100,000 x

5%

Amortizatied Premium (3) - (2)

Unamortized Premium (5) - (4)

P.V. at End 100,000 /

(5)

0 - - - - 8,114.50 108114.51 108,114.50 4,325 5,000 675 7,440 107,4402 107,440 4,298 5,000 702 6,738 106,7383 106,738 4,270 5,000 730 6,008 106,0084 106,008 4,240 5,000 760 5,248 108,2485 103,248 4,210 5,000 790 4,458 104,4586 104,458 4,178 5,000 822 3,616 103,6367 103,636 4,145 5,000 855 2,781 102,7818 102,781 4,111 5,000 889 ,892 101,8929 101,892 4,076 5,000 924 968 100,96810 100,965 4,039 5,000 968* 0 100,000

Total 41,885.50 50,000 8114.5

Interest Expense = Cash payment - Amortized premium = 50,000 - 8114.5 = 41,885.5

* Rounding Error of $ 7 (968-961 = 7)


Accounting for Bonds Payable -Bonds Are Issued at A Premium (Effective Interest Method)

J.E 1/1/x2 Cash 108,114.5B/P 100,000Premium on Bonds Payable 8114.5

6/30/x2 Interest Expense 4,325(Period 1) Premium on Bonds Payable 675

Cash 5,00012/31/x2 Interest Expense 4,298(period 2) Premium on Bonds Payable 702

: Cash 5,000:

6/30/x3Period3



(period 9)6/30/x6 Interest Expense 4,076

Premium on B/P 924Cash 5,000

12/31/x6 Interest Expense 4,032Premium on B/P 968

Cash 5,0001/1/x7 B/P 100,000

Cash 100,000(Retirement of Bonds at Maturity)



Premium on Bonds

6/30/x2… 675 8114.5 …1/1/x2

12/31/x2 … 702

730

760

790

822

855

889

924

968

0

Interest Expense over 10 periods =>

Period $

1 4,325

2 4,298

4,270

10

41,885.50


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


Bond Retirements Before Maturity (contd.)

B/P 100,000

Loss on Retirement of Bonds 3,582

Discount on Bonds Payable 5,582

Cash 98,000



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 558592 Amortized Dis. For period 4627 (6 month)

3 months (665/2)

bal. 5,249.5



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 100,000Interest Payable 2,500loss 2,249.5

Cash 99,500

Dis on B/P5,249.5


Other Types of Debt Extinguishment: (skip p90-92)

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.


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:


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.


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.


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.


Accounting for Bonds Sold Between Interest Payment Dates at Par:

J.E. 5/1/x2 (bond sold at par on 5/1/x2)Cash 102,500

Bonds Payable 100,000Interest Payable* 2,500

* Accrued interest of 3 months (From 2/1 ~ 5/1)

8/1/x2 Interest Payable* 2,500 Interest Expense 2,500

Cash 5,000* 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


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.


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


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



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



J.E. on 3/1/x2

Cash 196,123

Dis. On B/P 6,544**

B/P200,000

Interest Payable2,667

** (200,000 - 193,456) or (200,000 - 192,908) - 548



Schedule of Interest & B.V

6 Months Ending

Interest Expense

CashDiscount Amortize

dB.V

1/1/x2 - - - 192,908 7/1/x2 9,645* 8,000 1,645** 194,55312/31/x2 9,728 8,000 1,728 196,281 7/1/x3 9,814 8,000 1,814 198,09512/31/x3 9,905 8,000 1,905 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



7/1/x2 Interest Expense 6,4301

Interest Payable 2,6672

Discount on B/P1,097Cash 8,000

1. 9,645 x 4/6= 6,430

2. 1,645 x 4/6 = 1,097

12/31/x2 Interest Expense 9,728 Cash8,000 Discount on B/P1,728



7/1/x3 Interest Expense 9,814Cash 8,000Discount on B/P 1,814

12/31/x3 Interest Expense 9,905Cash 8,000Discount on B/P 1,905

Discount on B/P6,544 1,097

1,7281,8141,905

0


Accruing Bond Interest Assumed that Page Company issued a 5-year

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 92,640.50Discount 7,359.50

B/P

100,000


Accruing Bond Interest (contd.)12/31/x2 (adjusting entry for accrued interest expense)

(Straight -line method)Interest Expense 2,858

Interest Payable 2,500Discount 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 2,500Discount on B/P 279

* Effective Interest of 3 months:92,640.50 x (12% x 1/2) x 3/6 = 2,779


Accruing Bond Interest (contd.)

Effective Interest Method:4/1/x3 Interest Expense 2,779

Interest Payable 2,500 Cash 5,000 Discount on B/P 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


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


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.


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.


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.


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


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/P800,000

Comm. Stock Warrants23,764.71

* $800,000 -784,235.29 = 15,764.71


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 12,500 1

Common Stock Warrants 1,485.50 2

Common Stock 2,500 3

Additional Paid-in Capital on C.S 11,485.50 4

1. $25 x 500 2. 2.971 x 500 3. 5 x 500 4. (12,500 + 1485.50) - 2,500


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


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.

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.



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);


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.


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?)


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.


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).


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.


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).


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:


Example (contd.)

A. Book Value Method: (BV of the bonds= $10,500) (more commonly used by companies)

Bonds payable 10,000Premium on Bonds Payable 500

Common Stock 1 8,000Paid-in Capital from Bond Conversion 2 2,500

1. $20 x 40 x 102. 10,500 - 8,000


Example (contd.)

B. Market Value Method : (MV of converted Stock = 26.5 x (40x 10) = 10,600)

Bonds payable 10,000Premium on B/P 500Loss on Conversion 100

Common Stock 8,000 Paid-in Capital from Bond Conversion 2,600 1

1. 10,600 - 8,000


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.


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.


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.


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) 10,500Paid-in Capital in Excess * of Par Value 2,500

*13,000 - 10,500


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 Notes Payable

APB Opinion No. 21 requires the long-term 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 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.



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.



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.


Example

Johnson Company issued a 3-year, non-interest-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 5,694.24

Discount on Notes Payable 2,305.76

Note Payable8,000


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%


Year 1 Year 2 Year 3N/P 8,000 8,000 8,000Less: Unamortized Discount

(2,305.76) (1,622.45) (857.14)

Carrying Value (at beg.)

5,694.24 6,377.55 7,142.86

x Effective Rate 12% 12% 12%Interest Expense 683.31 765.31 857.14 - Interest Payment 0 0 0 Amortized Discount 683.31 765.31 857.14

Example (contd.)

The Interest Expense Per Year is Computed as:


Example (contd.)

Recognition of Interest Expense of Year 1:

Interest Expense 683.31

Discount on N/P683.31

Cash (non-interest bearing note)

0


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.


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. .


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.


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


Example (contd.)

End of first YearInterest Exp. (71,178 x 12%) 8,541.36

Discount on N/P 8,541.36Unearned Revenue (28,822/5) 5,764.40

Sales Revenue 5,764.40

End of Second YearInterest Exp. ((76,178 + 8,541.36) x 12%) 9,566.32

Discount on N/P 9,564.40Unearned Revenue 5,764.40

Sales Revenue 5,764.40


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.


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.


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.


Example

On 1/1/x5, Marden Company purchases an equipment by issuing a non-interest-bearing 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%.


Example (contd.)

J.E. 1/1/x5

Equipment 5,674.27*

Discount on N/P 4,325.73

N/P 10,000

* P.V. of the note using 12% as the effective interest rate => 10,000 x 0.567427


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)


Example (contd.)

12/31/x6

Int. Exp. (5,674.27 + 680.91) x 12% 762,62

Discount on N/P762.62

Depreciation Expense 567.43

Accumulated Depreciation567.43


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%.


Example (contd.)

The following entries would be recorded for 20x5 and 20x6:1/1/x5

Equipment 6,209.21Discount on N/P 3,790.89

N/P 10,00012/31/x5

Int. Exp. (6,209.21 x 10%) 621Discount on N/P 621

12/31/x6 Int. Exp. (6,209.21 + 621) x 10% 683

Discount on N/P 683


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


Installment Notes: (Contd.)

Journal Entries:1/1/x5 Equipment 6,209.21

Note Payable 6,209.21

12/31/x5 Interest Exp. * 621N/P 1,017

Cash1,638 *6,209.21 x 10% = 621

12/31/x6 Interest Exp. * 519N/P 1,119

Cash1,638 *(6,209.21 - 1,017) x 10% = 519.2


Installment Notes: (Contd.) Journal Entries:12/31/x7 Interest Exp. * 407 N/P

1,231 Cash1,638 *(6,209-1,017-1,119) x 10% =

40712/31/x8 Interest Exp. * 284 N/P

1,354 Cash1,638 *(6,209-1,017-1,119-1,231) x

10% = 28412/31/x9 Interest Exp. * 149 N/P

1,489 Cash1,638

*(6,209-1,017-1,119-1,231- 1,354) x10% = 149



N/P1017 62091119123113541489 0*rounding error = $1



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 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 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.


Example

Joyce Company accepted a $10,000, non-interest-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.


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 4,325.73Equipment 8,000 Gain on Sale of Equipment 3 674.27

1. 100,000 -5,674.272. 8,000 - 5,000 (B.V.)3. P.V. of the Note - B.V. of the Equipment = 5,674.27 - 5,000


Example (contd.)

12/31/x5Discount on N/R 1 680.91

Interest Revenue680.91

1. 5,674.27 x 12%

P.V. of Note on 1/1/95

12/31/x6 Discount on N/R 1 762.62

Interest Revenue762.62

1. (5,674.27 + 680.92) x 12%


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.


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.


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.


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:


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


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


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


Recognition of the Impairment (contd.)12/31/x2

Allowance for Doubtful Notes** 7,407.41

Interest Revenue7,407.41

** (85,733.93 + 6,858.71) x 8%


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.


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.



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.


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.


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 50Land(at fair value) 40Gain on troubled debt restructuring 10


A. Debt is Settled:


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.

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.



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



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.



Accounting Treatment (contd.): C) If entire accrued interests were

eliminated, all subsequent cash payments are payments for the debt itself.



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.



Extraordinary Gain:

Carrying Amount $55 million

Future Cash Payments* $46 million

Gain $ 9 million

* $3 million x 2+ 40 million = $46 million



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



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 3Cash 3

At maturity:Note Payable 40

Cash 40(revised principal amount)



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.



A new effective interest rate needs to be calculated as follows:$55,000,000 / $57,221,927=0.96117The present value table (6A-2) indicates that the new effective interest rate is 2%.



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) 1,100,000Interest Payable1,100,000



3)At the end of the second yearInterest Exp.* 1,122,000

Interest Payable1,122,000

* 2% x ($55million + 1,100,000)

4)At maturity Date: Note Payable 50,000,000Interest Payable 7,222,000

Cash57,222,000


Documents

Chapter 14 Bonds and Long-Term Notes Long-Term Liabilities 2 Topics of Long-Term Liabilities n Issuance of bonds (at a premium or discount) n Fair value