Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch14

688

C H A P T E R 14

LONG-TERM LIABI LITI ES

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:

Describe the formal procedures associated with issuing long-term debt.

Identify various types of bond issues.

Describe the accounting valuation for bonds at date of issuance.

Apply the methods of bond discount and premium amortization.

Describe the accounting for the extinguishment of debt.

Explain the accounting for long-term notes payable.

Explain the reporting of off-balance-sheet financing arrangements.

Indicate how to present and analyze long-term debt.•8

•7

•6

•5

•4

•3

•2

•1

Traditionally, investors in the stock and bond marketsoperate in their own separate worlds. However, in re-cent volatile markets, even quiet murmurs in the bond

market have been amplified into movements (usually negative) in stock prices. At one ex-treme, these gyrations heralded the demise of a company well before the investors couldsniff out the problem.

The swift decline of Enron in late 2001 provided the ultimate lesson: A company withno credit is no company at all. As one analyst remarked, “You can no longer have an opin-ion on a company’s stock without having an appreciation for its credit rating.” Other energycompanies, such as Calpine, NRG Energy, and AES Corp., also felt the effect of Enron’stroubles as lenders tightened or closed down the credit supply and raised interest rates onalready-high levels of debt. The result? Stock prices took a hit.

Another debt feature that can impact shareholders are bond covenants, which providebond investors various protections while at the same time constraining management. Suchcovenants may limit the payment of dividends or preclude the issuance of new debt. In somecases, covenants constrain the company from pursuing certain risky projects or prevent itfrom selling off assets. Why do companies offer these concessions? It is primarily because

Your Debt Is Killing My Stock

PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark

http://www.PDFWatermarkRemover.com/buy.htm

689

P R E V I E W O F C H A P T E R 1 4

As our opening story indicates, investors pay considerable attention to a company’sliabilities. The stock market severely punishes companies with high debt levels andthe related impact of higher interest costs on income performance. In this chapter weexplain the accounting issues related to long-term debt. The content and organizationof the chapter are as follows.

BONDS PAYABLE LONG-TERM NOTES PAYABLE

REPORT ING AND ANALYZ ING LONG-TERM DEBT

• Issuing bonds

• Types and ratings

• Valuation

• Effective-interest method

• Costs of issuing

• Extinguishment

• Notes issued at face value

• Notes not issued at face value

• Special situations

• Mortgage notes payable

• Off-balance-sheet financing

• Presentation and analysis

LONG-TERML IAB IL I T I ES

bond investors demand higher rates of return unless they are protected from the risk that the company will rewardshareholders at the bondholders’ expense.

A good example is Laboratory Corp. of America. It included a covenant in a recent bond issue offering to buythe bonds back at a premium (referred to as a call provision) if there is a change in control leading to a lowering of thedebt rating. Laboratory Corp. apparently felt offering the concession was worth it, since the company needed the pro-ceeds from the debt issue to fund its growth.

Other industries are not immune from the negative shareholder effects of credit problems. For example, analystsat TheStreet.com compiled a list of companies with high debt levels and low ability to cover interest costs. Amongthem is Goodyear Tire and Rubber, which reported debt six times greater than its equity. Goodyear is a classic ex-ample of how swift and crippling a heavy debt-load can be. Not too long ago, Goodyear had a good credit rating andwas paying a good dividend. But with mounting operating losses, Goodyear’s debt became a huge burden, its debtrating fell to junk-status, the company cut its dividend, and its stock price dropped 80%. This was yet another exam-ple of stock prices taking a hit due to concerns about credit quality. Thus, even if your investment tastes are in stocks,keep an eye on the liabilities.

Source: Adapted from Steven Vames, “Credit Quality, Stock Investing Seem to Go Hand in Hand,” Wall StreetJournal (April 1, 2002), p. R4; Herb Greenberg, “The Hidden Dangers of Debt,” Fortune (July 21, 2003), p. 153; andChristine Richard,“Holders of Corporate Bonds Seek Protection From Risk,” Wall Street Journal (December 17–18,2005), p. B4.



690 · Chapter 14 Long-Term Liabilities

Long-term debt consists of probable future sacrifices of economic benefits arisingfrom present obligations that are not payable within a year or the operating cycle ofthe company, whichever is longer. Bonds payable, long-term notes payable, mort-gages payable, pension liabilities, and lease liabilities are examples of long-termliabilities.

A corporation, per its bylaws, usually requires approval by the board of directorsand the stockholders before bonds or notes can be issued. The same holds true for othertypes of long-term debt arrangements.

Generally, long-term debt has various covenants or restrictions that protectboth lenders and borrowers. The indenture or agreement often includes theamounts authorized to be issued, interest rate, due date(s), call provisions, prop-erty pledged as security, sinking fund requirements, working capital and dividendrestrictions, and limitations concerning the assumption of additional debt. Com-panies should describe these features in the body of the financial statements or

the notes if important for a complete understanding of the financial position and theresults of operations.

Although it would seem that these covenants provide adequate protection to thelong-term debtholder, many bondholders suffer considerable losses when companiesadd more debt to the capital structure. Consider what can happen to bondholders inleveraged buyouts (LBOs), which are usually led by management. In an LBO of RJRNabisco, for example, solidly rated 93⁄8 percent bonds due in 2016 plunged 20 percentin value when management announced the leveraged buyout. Such a loss in value oc-curs because the additional debt added to the capital structure increases the likelihoodof default. Although covenants protect bondholders, they can still suffer losses whendebt levels get too high.

ISSUING BONDSA bond arises from a contract known as a bond indenture. A bond represents a prom-ise to pay: (1) a sum of money at a designated maturity date, plus (2) periodic interestat a specified rate on the maturity amount (face value). Individual bonds are evidencedby a paper certificate and typically have a $1,000 face value. Companies usually makebond interest payments semiannually, although the interest rate is generally expressedas an annual rate. The main purpose of bonds is to borrow for the long term when theamount of capital needed is too large for one lender to supply. By issuing bonds in$100, $1,000, or $10,000 denominations, a company can divide a large amount of long-term indebtedness into many small investing units, thus enabling more than one lenderto participate in the loan.

A company may sell an entire bond issue to an investment bank which acts as aselling agent in the process of marketing the bonds. In such arrangements, investmentbanks may either underwrite the entire issue by guaranteeing a certain sum to the com-pany, thus taking the risk of selling the bonds for whatever price they can get (firm un-derwriting). Or they may sell the bond issue for a commission on the proceeds of thesale (best-efforts underwriting). Alternatively, the issuing company may sell the bondsdirectly to a large institution, financial or otherwise, without the aid of an underwriter(private placement).

TYPES AND RATINGS OF BONDSPresented on the next page, we define some of the more common types of bonds foundin practice.

SECTION 1 • BON DS PAYABLE

Objective•1Describe the formal proceduresassociated with issuing long-termdebt.



Types and Ratings of Bonds · 691

Objective•2Identify various types ofbond issues.

SECURED AND UNSECURED BONDS. Secured bonds are backed by a pledgeof some sort of collateral. Mortgage bonds are secured by a claim on real estate.Collateral trust bonds are secured by stocks and bonds of other corporations.Bonds not backed by collateral are unsecured. A debenture bond is unsecured.A “junk bond” is unsecured and also very risky, and therefore pays a high inter-est rate. Companies often use these bonds to finance leveraged buyouts.

TERM, SERIAL BONDS, AND CALLABLE BONDS. Bond issues that matureon a single date are called term bonds; issues that mature in installments arecalled serial bonds. Serially maturing bonds are frequently used by school orsanitary districts, municipalities, or other local taxing bodies that receive moneythrough a special levy. Callable bonds give the issuer the right to call and retirethe bonds prior to maturity.

CONVERTIBLE, COMMODITY-BACKED, AND DEEP-DISCOUNT BONDS.If bonds are convertible into other securities of the corporation for a specifiedtime after issuance, they are convertible bonds.

Two types of bonds have been developed in an attempt to attract capital ina tight money market—commodity-backed bonds and deep-discount bonds.Commodity-backed bonds (also called asset-linked bonds) are redeemable inmeasures of a commodity, such as barrels of oil, tons of coal, or ounces of raremetal. To illustrate, Sunshine Mining, a silver-mining company, sold two issuesof bonds redeemable with either $1,000 in cash or 50 ounces of silver, whicheveris greater at maturity, and that have a stated interest rate of 81⁄2 percent. The ac-counting problem is one of projecting the maturity value, especially since silverhas fluctuated between $4 and $40 an ounce since issuance.

JCPenney Company sold the first publicly marketed long-term debt securi-ties in the United States that do not bear interest. These deep-discount bonds,also referred to as zero-interest debenture bonds, are sold at a discount that pro-vides the buyer’s total interest payoff at maturity.

REGISTERED AND BEARER (COUPON) BONDS. Bonds issued in the nameof the owner are registered bonds and require surrender of the certificate and is-suance of a new certificate to complete a sale. A bearer or coupon bond, how-ever, is not recorded in the name of the owner and may be transferred from oneowner to another by mere delivery.

INCOME AND REVENUE BONDS. Income bonds pay no interest unless theissuing company is profitable. Revenue bonds, so called because the interest onthem is paid from specified revenue sources, are most frequently issued by air-ports, school districts, counties, toll-road authorities, and governmental bodies.

TYPES OF BONDS

What do thenumbers mean?

How do investors monitor their bond investments? One way is to review the bond listings foundin the newspaper or online. Corporate bond listings show the coupon (interest) rate, maturity date,and last price. However, because corporate bonds are more actively held by large institutional in-vestors, the listings also indicate the current yield and the volume traded. Corporate bond listingswould look like those below.

Coupon Price: Yield: Volume Issuer Maturity High/Low High/Low ($, 000)

BellSouth Corp. 6.000 102.190 5.83911/15/2034 95.370 6.357 23,125

General Motors Corp. 8.375 96.426 8.72107/15/2033 86.781 9.779 923,072

ALL ABOUT BONDS




VALUATION OF BONDS PAYABLE—DISCOUNT AND PREMIUM

The issuance and marketing of bonds to the public does not happen overnight. Itusually takes weeks or even months. First, the issuing company must arrange forunderwriters that will help market and sell the bonds. Then it must obtain the Se-curities and Exchange Commission’s approval of the bond issue, undergo audits,and issue a prospectus (a document which describes the features of the bond and

related financial information). Finally, the company must generally have the bondcertificates printed. Frequently the issuing company establishes the terms of a bondindenture well in advance of the sale of the bonds. Between the time the company setsthese terms and the time it issues the bonds, the market conditions and the financialposition of the issuing corporation may change significantly. Such changes affect themarketability of the bonds and thus their selling price.

The selling price of a bond issue is set by the supply and demand of buyers andsellers, relative risk, market conditions, and the state of the economy. The investmentcommunity values a bond at the present value of its expected future cash flows, which

consist of (1) interest and (2) principal. The rate used to compute the present valueof these cash flows is the interest rate that provides an acceptable return on an in-vestment commensurate with the issuer’s risk characteristics.

The interest rate written in the terms of the bond indenture (and often printedon the bond certificate) is known as the stated, coupon, or nominal rate. The issuerof the bonds sets this rate. The stated rate is expressed as a percentage of the facevalue of the bonds (also called the par value, principal amount, or maturity value).

If the rate employed by the investment community (buyers) differs from thestated rate, the present value of the bonds computed by the buyers (and the current


(continued)

The companies issuing the bonds are listed in the first column, in this case, a telecommunicationscompany, BellSouth Corp., and the automaker General Motors Corp. Immediately after the namesis a column with the interest rate paid by the bond as a percentage of its par value, with its matu-rity date below. The BellSouth bonds, for example, pay 6 percent and mature on November 15, 2034.The General Motors bonds pay 8.375 percent, quite a bit more.

The BellSouth bonds have a current yield of 6.3 percent based on the closing low price of 95.370per $1,000. The high/low prices are based on trading in a five-day period, in which the volumetraded on the exchange amounted to $23,125 million. The General Motors bonds, at the high priceof 96.426, yield 8.721 percent. The GM bonds had volume of nearly $1 billion dollars.

Also, as indicated in the chapter, interest rates and the bond’s term to maturity have a real ef-fect on bond prices. For example, an increase in interest rates will lead to a decline in bond values.Similarly, a decrease in interest rates will lead to a rise in bond values. The data reported below,based on three different bond funds, demonstrate these relationships between interest rate changesand bond values.

Bond Price Changes in Response to 1% Interest Rate 1% Interest RateInterest Rate Changes Increase Decrease

Short-term fund (2–5 years) �2.5% �2.5%Intermediate-term fund (5 years) �5% �5%Long-term fund (10 years) �10% �10%

Data source: The Vanguard Group.

Another factor that affects bond prices is the call feature, which decreases the value of the bond.Investors must be rewarded for the risk that the issuer will call the bond if interest rates decline,which would force the investor to reinvest at lower rates.

Source: The Bond Market Association (www.investinginbonds.com) (accessed March 2007).

Objective•3Describe the accounting valuationfor bonds at date of issuance.

Both iGAAP and U.S. GAAP permit valuation of long-term debt andother liabilities at fair value with gainsand losses on changes in fair valuerecorded in income (referred to as the“fair value option”) in certain situations.

INTERNATIONALINSIGHT



Valuation of Bonds Payable—Discount and Premium · 693

purchase price) will differ from the face value of the bonds. The difference between theface value and the present value of the bonds determines the actual price that buyerspay for the bonds. This difference is either a discount or premium.1

• If the bonds sell for less than face value, they sell at a discount.• If the bonds sell for more than face value, they sell at a premium.

The rate of interest actually earned by the bondholders is called the effective yieldor market rate. If bonds sell at a discount, the effective yield exceeds the stated rate.Conversely, if bonds sell at a premium, the effective yield is lower than the stated rate.Several variables affect the bond’s price while it is outstanding, most notably the mar-ket rate of interest. There is an inverse relationship between the market interest rateand the price of the bond.

Here we consider an example to illustrate the computation of the present value ofa bond issue. Assume that ServiceMaster issues $100,000 in bonds, due in five yearswith 9 percent interest payable annually at year-end. At the time of issue, the marketrate for such bonds is 11 percent. The time diagram in Illustration 14-1 depicts both theinterest and the principal cash flows.

1It is generally the case that the stated rate of interest on bonds is set in rather precisedecimals (such as 10.875 percent). Companies usually attempt to align the stated rate asclosely as possible with the market or effective rate at the time of issue.

PVPVPV

PV–OA

4n = 5

i = 11%

2 3 50 1

$9,000 Interest

$100,000 Principal

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

ILLUSTRATION 14-1Time Diagram for BondCash Flows

The actual principal and interest cash flows are discounted at an 11 percent ratefor five periods as shown in Illustration 14-2.

Present value of the principal:$100,000 � .59345 (Table 6-2) $59,345.00

Present value of the interest payments:$9,000 � 3.69590 (Table 6-4) 33,263.10

Present value (selling price) of the bonds $92,608.10

ILLUSTRATION 14-2Present ValueComputation of BondSelling at a Discount

By paying $92,608.10 at the date of issue, investors realize an effective rate or yieldof 11 percent over the five-year term of the bonds. These bonds would sell at a discountof $7,391.90 ($100,000 � $92,608.10). The price at which the bonds sell is typically statedas a percentage of the face or par value of the bonds. For example, the ServiceMasterbonds sold for 92.6 (92.6% of par). If ServiceMaster had received $102,000, then thebonds sold for 102 (102% of par).

When bonds sell at less than face value, it means that investors demand a rate of in-terest higher than the stated rate. Usually this occurs because the investors can earn agreater rate on alternative investments of equal risk. They cannot change the stated rate,so they refuse to pay face value for the bonds. Thus, by changing the amount invested,they alter the effective rate of return. The investors receive interest at the stated rate com-puted on the face value, but they actually earn at an effective rate that exceeds the statedrate because they paid less than face value for the bonds. (Later in the chapter, in Illus-trations 14-6 and 14-7, we show an illustration for a bond that sells at a premium.)





Two major publication companies, Moody’s Investors Service and Standard & Poor’s Corporation,issue quality ratings on every public debt issue. The following table summarizes the ratings issuedby Standard & Poor’s, along with historical default rates on bonds with different ratings. As ex-pected, bonds receiving the highest quality rating of AAA have the lowest historical default rates.Bonds rated below BBB, which are considered below investment grade (“junk bonds”), experiencedefault rates ranging from 20 to 50 percent.

Original rating AAA AA A BBB BB B CCCDefault rate 0.52% 1.31 2.32 6.64 19.52 35.76 54.38

Data source: Standard & Poor’s Corp.

Debt ratings reflect credit quality. The market closely monitors these ratings when determiningthe required yield and pricing of bonds at issuance and in periods after issuance, especially if abond’s rating is upgraded or downgraded. Data on recent downgrades suggest that the number of“fallen angels” (downgraded debt) is on the rise.

HOW’S MY RATING?

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007(est.)0

10

20

30

40

50

60

70

80

(Issuers)90

(US$ Billion)600

500

400

300

200

100

Number of IssuersPar Bonds Affected

As recently as 1999, the number and amount of upgrades exceeded downgrades. However,following a decline in 2003, the number of fallen angels increased from 2004–2006, and 2007 is es-timated to come in at record levels. It is not surprising, then, that bond investors and companieswho issue bonds keep a close watch on debt ratings—both when bonds are issued and while thebonds are outstanding.

Source: A. Borrus, M. McNamee, and H. Timmons, “The Credit Raters: How They Work and How They Might WorkBetter,” Business Week (April 8, 2002), pp. 38–40; Standard and Poors, Global Fixed Income Research, “Fallen Angel Ac-tivity” (February 6, 2007); and S. Scholtes, “Bondholders Seek Stability,” Financial Times (December 19, 2007), p. 38.

Source: Standard & Poor’s Global Fixed Income Research (February 6, 2007).

Bonds Issued at Par on Interest DateWhen a company issues bonds on an interest payment date at par (face value), it ac-crues no interest. No premium or discount exists. The company simply records the cashproceeds and the face value of the bonds. To illustrate, if Buchanan Company issues atpar 10-year term bonds with a par value of $800,000, dated January 1, 2010, and bearing



Valuation of Bonds Payable—Discount and Premium · 695

interest at an annual rate of 10 percent payable semiannually on January 1 and July 1,it records the following entry:

Cash 800,000

Bonds Payable 800,000

Buchanan records the first semiannual interest payment of $40,000 ($800,000 � .10 � 1/2) on July 1, 2010, as follows.

Bond Interest Expense 40,000

Cash 40,000

It records accrued interest expense at December 31, 2010 (year-end) as follows.


Bond Interest Payable 40,000

Bonds Issued at Discount or Premium on Interest DateIf Buchanan Company issues the $800,000 of bonds on January 1, 2010, at 97 (mean-ing 97 percent of par), it records the issuance as follows.

Cash ($800,000 � .97) 776,000

Discount on Bonds Payable 24,000


Recall from our earlier discussion that because of its relation to interest, compa-nies amortize the discount and charge it to interest expense over the period of timethat the bonds are outstanding.

The straight-line method amortizes a constant amount each interest period (in thiscase 20 interest periods).2 For example, using the bond discount of $24,000, Buchananamortizes $1,200 to interest expense each period for 20 periods ($24,000 � 20).

Buchanan records the first semiannual interest payment of $40,000 ($800,000 �10% � 1/2) and the bond discount on July 1, 2010 as follows:



Cash 40,000

At December 31, 2010, Buchanan makes the following adjusting entry:




At the end of the first year, 2010, the balance in the Discount on Bonds Payable accountis $21,600 ($24,000 � $1,200 � $1,200). Over the term of the bonds, the balance in theDiscount on Bonds Payable will decrease by the same amount until it has zero balanceat the maturity date of the bonds.

If instead of issuing the bonds on January 1, 2010, Buchanan dates and sells thebonds on October 1, 2010, and if the fiscal year of the corporation ends on December31, the discount amortized during 2010 would be only 3/12 of 1/10 of $24,000, or $600.Buchanan must also record three months of accrued interest on December 31.

Premium on Bonds Payable is accounted for in a manner similar to that for Dis-count on Bonds Payable. If Buchanan dates and sells 10-year bonds with a par valueof $800,000 on January 1, 2010, at 103, it records the issuance as follows.

Cash ($800,000 � 1.03) 824,000

Premium on Bonds Payable 24,000


Objective•4Apply the methods of bond dis-count and premium amortization.

2The effective-interest method is preferred for amortization of discount or premium. To keepthese initial illustrations simple, we have chosen to use the straight-line method.




With the bond premium of $24,000, Buchanan amortizes $1,200 to interest expenseeach period for 20 periods ($24,000 � 20).

Buchanan records the first semiannual interest payment of $40,000 ($800,000 �10% � 1/2) and the bond premium on July 1, 2010 as follows:



Cash 40,000

At December 31, 2010, Buchanan makes the following adjusting entry:Bond Interest Expense 38,800



Amortization of a discount increases bond interest expense. Amortization of a pre-mium decreases bond interest expense. Later in the chapter we discuss amortizationof a discount or premium under the effective-interest method.

The issuer may call some bonds at a stated price after a certain date. This call fea-ture gives the issuing corporation the opportunity to reduce its bonded indebtednessor take advantage of lower interest rates. Whether callable or not, a company mustamortize any premium or discount over the bond’s life to maturity because early re-demption (call of the bond) is not a certainty.

Bonds Issued Between Interest DatesCompanies usually make bond interest payments semiannually, on dates specified inthe bond indenture. When companies issue bonds on other than the interest paymentdates, buyers of the bonds will pay the seller the interest accrued from the last in-terest payment date to the date of issue. The purchasers of the bonds, in effect, paythe bond issuer in advance for that portion of the full six-months’ interest payment towhich they are not entitled because they have not held the bonds for that period. Then,on the next semiannual interest payment date, purchasers will receive the full six-months’ interest payment.

To illustrate, assume that on March 1, 2010, Taft Corporation issues 10-year bonds,dated January 1, 2010, with a par value of $800,000. These bonds have an annual inter-est rate of 6 percent, payable semiannually on January 1 and July 1. Because Taft issuesthe bonds between interest dates, it records the bond issuance at par plus accruedinterest as follows.

Cash 808,000


Bond Interest Expense ($800,000 � .06 � 2/12) 8,000

(Interest Payable might be credited instead)

The purchaser advances two months’ interest. On July 1, 2010, four months after thedate of purchase, Taft pays the purchaser six months’ interest. Taft makes the follow-ing entry on July 1, 2010.


Cash 24,000

The Bond Interest Expense account now contains a debit balance of $16,000, which rep-resents the proper amount of interest expense—four months at 6 percent on $800,000.

The illustration above was simplified by having the January 1, 2010, bonds issuedon March 1, 2010, at par. If, however, Taft issued the 6 percent bonds at 102, its March 1entry would be:

Cash [($800,000 � 1.02) � ($800,000 � .06 � 2/12)] 824,000


Premium on Bonds Payable ($800,000 � .02) 16,000


Taft would amortize the premium from the date of sale (March 1, 2010), not from thedate of the bonds (January 1, 2010).



Effective-Interest Method · 697

EFFECTIVE-INTEREST METHODThe preferred procedure for amortization of a discount or premium is the effective-interest method (also called present value amortization). Under the effective-interestmethod, companies:

1. Compute bond interest expense first by multiplying the carrying value (book value)of the bonds at the beginning of the period by the effective interest rate.3

2. Determine the bond discount or premium amortization next by comparing the bondinterest expense with the interest (cash) to be paid.

Illustration 14-3 depicts graphically the computation of the amortization.

3The carrying value is the face amount minus any unamortized discount or plus anyunamortized premium. The term carrying value is synonymous with book value.4Because companies pay interest semiannually, the interest rate used is 5% (10% � 6⁄12).The number of periods is 10 (5 years � 2).

AmortizationAmount

Carrying Valueof Bonds at

Beginning of Period

EffectiveInterest

Rate×

Bond Interest Expense

Face Amountof

Bonds

StatedInterest

Rate×

Bond Interest Paid

–– ==

ILLUSTRATION 14-3Bond Discount andPremium AmortizationComputation

The effective-interest method produces a periodic interest expense equal to a con-stant percentage of the carrying value of the bonds. Since the percentage is the effec-tive rate of interest incurred by the borrower at the time of issuance, the effective-interest method matches expenses with revenues better than the straight-line method.

Both the effective-interest and straight-line methods result in the same total amountof interest expense over the term of the bonds. However, when the annual amountsare materially different, generally accepted accounting principles require use of theeffective-interest method. [1]

Bonds Issued at a DiscountTo illustrate amortization of a discount under the effective-interest method, Ever-master Corporation issued $100,000 of 8 percent term bonds on January 1, 2010, dueon January 1, 2015, with interest payable each July 1 and January 1. Because the in-vestors required an effective-interest rate of 10 percent, they paid $92,278 for the$100,000 of bonds, creating a $7,722 discount. Evermaster computes the $7,722 dis-count as follows.4

Maturity value of bonds payable $100,000Present value of $100,000 due in 5 years at 10%, interest payable

semiannually (Table 6-2); FV(PVF10,5%); ($100,000 � .61391) $61,391Present value of $4,000 interest payable semiannually for 5 years at

10% annually (Table 6-4); R(PVF-OA10,5%); ($4,000 � 7.72173) 30,887

Proceeds from sale of bonds 92,278

Discount on bonds payable $ 7,722

ILLUSTRATION 14-4Computation of Discounton Bonds Payable

See the FASBCodification section(page 723).




The five-year amortization schedule appears in Illustration 14-5.

SCHEDULE OF BOND DISCOUNT AMORTIZATIONEFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS

5-YEAR, 8% BONDS SOLD TO YIELD 10%

Carrying Cash Interest Discount Amount

Date Paid Expense Amortized of Bonds

1/1/10 $ 92,2787/1/10 $ 4,000a $ 4,614b $ 614c 92,892d

1/1/11 4,000 4,645 645 93,5377/1/11 4,000 4,677 677 94,2141/1/12 4,000 4,711 711 94,9257/1/12 4,000 4,746 746 95,6711/1/13 4,000 4,783 783 96,4547/1/13 4,000 4,823 823 97,2771/1/14 4,000 4,864 864 98,1417/1/14 4,000 4,907 907 99,0481/1/15 4,000 4,952 952 100,000

$40,000 $47,722 $7,722

a$4,000 � $100,000 � .08 � 6/12 c$614 � $4,614 � $4,000b$4,614 � $92,278 � .10 � 6/12 d$92,892 � $92,278 � $614

ILLUSTRATION 14-5Bond DiscountAmortization Schedule

Calculator Solution forPresent Valueof Bonds:

N

Inputs

10

I/YR 5

PV ?

PMT –4,000

FV –100,000

92,278

Answer

Evermaster records the issuance of its bonds at a discount on January 1, 2010, asfollows:

Cash 92,278



It records the first interest payment on July 1, 2010, and amortization of the dis-count as follows:


Discount on Bonds Payable 614

Cash 4,000

Evermaster records the interest expense accrued at December 31, 2010 (year-end)and amortization of the discount as follows:



Discount on Bonds Payable 645

Bonds Issued at a PremiumNow assume that for the bond issue described above, investors are willing to acceptan effective interest rate of 6 percent. In that case, they would pay $108,530 or a pre-mium of $8,530, computed as follows.

Maturity value of bonds payable $100,000Present value of $100,000 due in 5 years at 6%, interest payable

semiannually (Table 6-2); FV(PVF10,3%); ($100,000 � .74409) $74,409Present value of $4,000 interest payable semiannually for 5 years at

6% annually (Table 6-4); R(PVF-OA10,3%); ($4,000 � 8.53020) 34,121

Proceeds from sale of bonds 108,530

Premium on bonds payable $ 8,530

ILLUSTRATION 14-6Computation of Premiumon Bonds Payable



Effective-Interest Method · 699

The five-year amortization schedule appears in Illustration 14-7.

SCHEDULE OF BOND PREMIUM AMORTIZATIONEFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS

5-YEAR, 8% BONDS SOLD TO YIELD 6%

CarryingCash Interest Premium Amount

Date Paid Expense Amortized of Bonds

1/1/10 $108,5307/1/10 $ 4,000a $ 3,256b $ 744c 107,786d

1/1/11 4,000 3,234 766 107,0207/1/11 4,000 3,211 789 106,2311/1/12 4,000 3,187 813 105,4187/1/12 4,000 3,162 838 104,5801/1/13 4,000 3,137 863 103,7177/1/13 4,000 3,112 888 102,8291/1/14 4,000 3,085 915 101,9147/1/14 4,000 3,057 943 100,9711/1/15 4,000 3,029 971 100,000

$40,000 $31,470 $8,530

a$4,000 � $100,000 � .08 � 6/12 c$744 � $4,000 � $3,256b$3,256 � $108,530 � .06 � 6/12 d$107,786 � $108,530 � $744

ILLUSTRATION 14-7Bond PremiumAmortization Schedule

Calculator Solution forPresent Valueof Bonds:

N

Inputs

10

I/YR 3

PV ?

PMT –4,000

FV –100,000

108,530

Answer

Evermaster records the issuance of its bonds at a premium on January 1, 2010, asfollows:

Cash 108,530



Evermaster records the first interest payment on July 1, 2010, and amortization ofthe premium as follows:


Premium on Bonds Payable 744

Cash 4,000

Evermaster should amortize the discount or premium as an adjustment to interestexpense over the life of the bond in such a way as to result in a constant rate of inter-est when applied to the carrying amount of debt outstanding at the beginning of anygiven period.

Accruing InterestIn our previous examples, the interest payment dates and the date the financial state-ments were issued were the same. For example, when Evermaster sold bonds at apremium (page 698), the two interest payment dates coincided with the financial re-porting dates. However, what happens if Evermaster wishes to report financial state-ments at the end of February 2010? In this case, the company prorates the premiumby the appropriate number of months, to arrive at the proper interest expense, asfollows.

Interest accrual ($4,000 � 2⁄6) $1,333.33Premium amortized ($744 � 2⁄6) (248.00)

Interest expense (Jan.–Feb.) $1,085.33

ILLUSTRATION 14-8Computation of InterestExpense




The interest-accrual computation is much simpler if the company uses the straight-line method. For example, the total premium is $8,530, which Evermaster allocatesevenly over the five-year period. Thus, premium amortization per month is $142.17($8,530 � 60 months).

Classification of Discount and PremiumDiscount on bonds payable is not an asset. It does not provide any future economicbenefit. In return for the use of borrowed funds, a company must pay interest. A bonddiscount means that the company borrowed less than the face or maturity value of thebond. It therefore faces an actual (effective) interest rate higher than the stated (nomi-nal) rate. Conceptually, discount on bonds payable is a liability valuation account. Thatis, it reduces the face or maturity amount of the related liability.5 This account is re-ferred to as a contra account.

Similarly, premium on bonds payable has no existence apart from the related debt.The lower interest cost results because the proceeds of borrowing exceed the face ormaturity amount of the debt. Conceptually, premium on bonds payable is a liabilityvaluation account. It adds to the face or maturity amount of the related liability.6 Thisaccount is referred to as an adjunct account. As a result, companies report bond dis-counts and bond premiums as a direct deduction from or addition to the face amountof the bond.

COSTS OF ISSUING BONDSThe issuance of bonds involves engraving and printing costs, legal and accounting fees,commissions, promotion costs, and other similar charges. Companies are required tocharge these costs to an asset account, often referred to as Unamortized Bond IssueCosts. Companies then allocate these Unamortized Bond Issue Costs over the life ofthe debt, in a manner similar to that used for discount on bonds. [2]

We disagree with this approach. Unamortized bond issue cost in our view is an ex-pense (or a reduction of the related liability).

Apparently the FASB also disagrees with the current GAAP treatment and notesin Concepts Statement No. 6 that debt issue cost is not considered an asset because itprovides no future economic benefit. The cost of issuing bonds, in effect, reduces theproceeds of the bonds issued and increases the effective interest rate. Companies maythus account for it the same as the unamortized discount.

There is an obvious difference between GAAP and Concepts Statement No. 6’s viewof debt issue costs. However, until an issued standard supersedes existing GAAP, un-amortized bond issue costs are treated as a deferred charge and amortized over thelife of the debt.

Evermaster records this accrual as follows.Bond Interest Expense 1,085.33

Premium on Bonds Payable 248.00

Bond Interest Payable 1,333.33

If the company prepares financial statements six months later, it follows the sameprocedure. That is, the premium amortized would be as follows.

Premium amortized (March–June) ($744 � 4⁄6) $496.00Premium amortized (July–August) ($766 � 2⁄6) 255.33

Premium amortized (March–August 2004) $751.33

ILLUSTRATION 14-9Computation of PremiumAmortization

5“Elements of Financial Statements of Business Enterprises,” Statement of Financial AccountingConcepts No. 6 (Stamford, Conn.: FASB, 1980).6Ibid., par. 238.



Extinguishment of Debt · 701

To illustrate the accounting for costs of issuing bonds, assume that Microchip Cor-poration sold $20,000,000 of 10-year debenture bonds for $20,795,000 on January 1, 2010(also the date of the bonds). Costs of issuing the bonds were $245,000. Microchip recordsthe issuance of the bonds and amortization of the bond issue costs as follows.

January 1, 2010

Cash 20,550,000

Unamortized Bond Issue Costs 245,000


Bonds Payable 20,000,000(To record issuance of bonds)

December 31, 2010

Bond Issue Expense 24,500

Unamortized Bond Issue Costs 24,500(To amortize one year of bond issuecosts—straight-line method)

Microchip continues to amortize the bond issue costs in the same way over the lifeof the bonds. Although the effective-interest method is preferred, in practice compa-nies may use the straight-line method to amortize bond issue costs because it is easierand the results are not materially different.

EXTINGUISHMENT OF DEBTHow do companies record the payment of debt—often referred to as extinguish-ment of debt? If a company holds the bonds (or any other form of debt security)to maturity, the answer is straightforward: The company does not compute anygains or losses. It will have fully amortized any premium or discount and anyissue costs at the date the bonds mature. As a result, the carrying amount willequal the maturity (face) value of the bond. As the maturity or face value will alsoequal the bond’s market value at that time, no gain or loss exists.

In some cases, a company extinguishes debt before its maturity date.7 The amountpaid on extinguishment or redemption before maturity, including any call premiumand expense of reacquisition, is called the reacquisition price. On any specified date,the net carrying amount of the bonds is the amount payable at maturity, adjusted forunamortized premium or discount, and cost of issuance. Any excess of the net carry-ing amount over the reacquisition price is a gain from extinguishment. The excess ofthe reacquisition price over the net carrying amount is a loss from extinguishment. Atthe time of reacquisition, the unamortized premium or discount, and any costs of issueapplicable to the bonds, must be amortized up to the reacquisition date.

To illustrate, assume that on January 1, 2003, General Bell Corp. issued at 97 bondswith a par value of $800,000, due in 20 years. It incurred bond issue costs totaling$16,000. Eight years after the issue date, General Bell calls the entire issue at 101 andcancels it.8 At that time, the unamortized discount balance is $14,400, and the unamortized

Objective•5Describe the accounting for theextinguishment of debt.

7Some companies have attempted to extinguish debt through an in-substance defeasance.In-substance defeasance is an arrangement whereby a company provides for the futurerepayment of a long-term debt issue by placing purchased securities in an irrevocable trust.The company pledges the principal and interest of the securities in the trust to pay off theprincipal and interest of its own debt securities as they mature. However, it is not legallyreleased from its primary obligation for the debt that is still outstanding. In some cases, debtholders are not even aware of the transaction and continue to look to the company forrepayment. This practice is not considered an extinguishment of debt, and therefore thecompany does not record a gain or loss.8The issuer of callable bonds must generally exercise the call on an interest date. Therefore,the amortization of any discount or premium will be up to date, and there will be no accruedinterest. However, early extinguishments through purchases of bonds in the open market aremore likely to be on other than an interest date. If the purchase is not made on an interestdate, the discount or premium must be amortized, and the interest payable must be accruedfrom the last interest date to the date of purchase.




issue cost balance is $9,600. Illustration 14-10 indicates how General Bell computes theloss on redemption (extinguishment).

Reacquisition price ($800,000 � 1.01) $808,000Net carrying amount of bonds redeemed:

Face value $800,000Unamortized discount ($24,000* � 12/20) (14,400)Unamortized issue costs ($16,000 � 12/20)

(both amortized using straight-line basis) (9,600) 776,000

Loss on redemption $ 32,000

*[$800,000 � (1 � .97)]

ILLUSTRATION 14-10Computation of Loss onRedemption of Bonds


As the opening story in the chapter indicated, high debt levels translate into high interest costs, whichare a drag on profitability. The chart below shows that the ratio of interest payments to earnings hasbeen on an upward trend. This is bad news for companies that have a lot of debt on their balance sheet.

DEAD-WEIGHT DEBT

Debt service vs. profits40%

30

20

10

01996 1997 1998 1999 2000 2001 2002

Ratio of net interestpayments to earnings*

*Earnings before tax and interest Data: HSBC Securities Inc., Commerce Dept.

General Bell records the reacquisition and cancellation of the bonds as follows:Bonds Payable 800,000

Loss on Redemption of Bonds 32,000


Unamortized Bond Issue Costs 9,600

Cash 808,000

Note that it is often advantageous for the issuer to acquire the entire outstandingbond issue and replace it with a new bond issue bearing a lower rate of interest. Thereplacement of an existing issuance with a new one is called refunding. Whether theearly redemption or other extinguishment of outstanding bonds is a nonrefunding ora refunding situation, a company should recognize the difference (gain or loss) betweenthe reacquisition price and the net carrying amount of the redeemed bonds in incomeof the period of redemption.9

9Companies at one time reported gains and losses on extinguishment of debt as extraordinaryitems. In response to concerns that such gains or losses are neither unusual nor infrequent,the FASB eliminated extraordinary item treatment for extinguishment of debt. [3]



Notes Issued at Face Value · 703


(continued)

However, in a low interest rate environment, as experienced at least through 2008, companieswith debt-laden balance sheets benefit when interest rates fall. Exelon Corp., a Chicago-based energycompany, is a good example. Exelon has been refinancing its long-term debt by retiring bonds with6.5 percent rates in exchange for newly issued bonds with rates ranging from 3.7 percent to 5.9 per-cent. This refinancing saved Exelon approximately $30 million dollars in annual interest costs.Exelon was able to get out of its higher cost debt when the getting was good. Other debt-ladencompanies might not fare so well if interest rates rise before they can refinance.

Source: Adapted from Gregory Zuckerman, “Climb of Corporate Debt Trips Analysts’ Alarm,” Wall StreetJournal (December 31, 2001), p. C1; and James Mehring, “The Dead Weight of Debt,” Business Week (February 24,2003), p. 60.

The difference between current notes payable and long-term notes payable is thematurity date. As discussed in Chapter 13, short-term notes payable are those thatcompanies expect to pay within a year or the operating cycle—whichever is longer.Long-term notes are similar in substance to bonds in that both have fixed matu-rity dates and carry either a stated or implicit interest rate. However, notes do nottrade as readily as bonds in the organized public securities markets. Noncorporate andsmall corporate enterprises issue notes as their long-term instruments. Larger corpora-tions issue both long-term notes and bonds.

Accounting for notes and bonds is quite similar. Like a bond, a note is valued atthe present value of its future interest and principal cash flows. The company amor-tizes any discount or premium over the life of the note, just as it would the discountor premium on a bond.10 Companies compute the present value of an interest-bearingnote, record its issuance, and amortize any discount or premium and accrual of interestin the same way that they do for bonds (as shown on pages 692–700 of this chapter).

As you might expect, accounting for long-term notes payable parallels accountingfor long-term notes receivable as was presented in Chapter 7.

NOTES ISSUED AT FACE VALUEIn Chapter 7, we discussed the recognition of a $10,000, three-year note ScandinavianImports issued at face value to Bigelow Corp. In this transaction, the stated rate andthe effective rate were both 10 percent. The time diagram and present value computa-tion on page 332 of Chapter 7 (see Illustration 7-9) for Bigelow Corp. would be thesame for the issuer of the note, Scandinavian Imports, in recognizing a note payable.Because the present value of the note and its face value are the same, $10,000, Scandi-navian would recognize no premium or discount. It records the issuance of the note asfollows.

Cash 10,000

Notes Payable 10,000

SECTION 2 • LONG-TERM NOTES PAYABLE

Objective•6Explain the accounting for long-termnotes payable.

10All payables that represent commitments to pay money at a determinable future date are subject to present value measurement techniques, except for the following specificallyexcluded types:

1. Normal accounts payable due within one year.2. Security deposits, retainages, advances, or progress payments.3. Transactions between parent and subsidiary.4. Obligations payable at some indeterminable future date. [4]




Scandinavian Imports would recognize the interest incurred each year as follows.Interest Expense 1,000

Cash 1,000

NOTES NOT ISSUED AT FACE VALUEZero-Interest-Bearing NotesIf a company issues a zero-interest-bearing (non-interest-bearing) note11 solely for cash,it measures the note’s present value by the cash received. The implicit interest rate isthe rate that equates the cash received with the amounts to be paid in the future. Theissuing company records the difference between the face amount and the present value(cash received) as a discount and amortizes that amount to interest expense over thelife of the note.

An example of such a transaction is Beneficial Corporation’s offering of $150 mil-lion of zero-coupon notes (deep-discount bonds) having an eight-year life. With a facevalue of $1,000 each, these notes sold for $327—a deep discount of $673 each. The pres-ent value of each note is the cash proceeds of $327. We can calculate the interest rateby determining the rate that equates the amount the investor currently pays with theamount to be received in the future. Thus, Beneficial amortizes the discount over theeight-year life of the notes using an effective interest rate of 15 percent.12

To illustrate the entries and the amortization schedule, assume that Turtle CoveCompany issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Com-pany illustrated on page 333 of Chapter 7 (notes receivable). The implicit rate thatequated the total cash to be paid ($10,000 at maturity) to the present value of the fu-ture cash flows ($7,721.80 cash proceeds at date of issuance) was 9 percent. (The pres-ent value of $1 for 3 periods at 9 percent is $0.77218.) Illustration 14-11 shows the timediagram for the single cash flow.

Inputs Answer

N 8

I/YR ?

PV -327

PMT 0

FV 1,000

15

Calculator Solution forEffective Intereston Note:

11Although we use the term “note” throughout this discussion, the basic principles andmethodology apply equally to other long-term debt instruments.12$327 � $1,000(PVF8,i)

.327 � 15% (in Table 6-2 locate .32690).

PVF8,i �$327

$1,000� .327

n = 3

i = 9%

2 30 1

$0 Interest

$10,000 Principal

$0$0PV–OA

PVILLUSTRATION 14-11Time Diagram for Zero-Interest Note

Turtle Cove records issuance of the note as follows.Cash 7,721.80

Discount on Notes Payable 2,278.20

Notes Payable 10,000.00

Turtle Cove amortizes the discount and recognizes interest expense annually us-ing the effective-interest method. Illustration 14-12 (on page 705) shows the three-yeardiscount amortization and interest expense schedule. (This schedule is similar to thenote receivable schedule of Jeremiah Company in Illustration 7-11.)



Notes Not Issued at Face Value · 705

SCHEDULE OF NOTE DISCOUNT AMORTIZATIONEFFECTIVE-INTEREST METHOD0% NOTE DISCOUNTED AT 9%

CarryingCash Interest Discount AmountPaid Expense Amortized of Note

Date of issue $ 7,721.80End of year 1 $–0– $ 694.96a $ 694.96b 8,416.76c

End of year 2 –0– 757.51 757.51 9,174.27End of year 3 –0– 825.73d 825.73 10,000.00

$–0– $2,278.20 $2,278.20

a$7,721.80 � .09 � $694.96 c$7,721.80 � $694.96 � $8,416.76b$694.96 � 0 � $694.96 d5¢ adjustment to compensate for rounding

ILLUSTRATION 14-12Schedule of Note DiscountAmortization

SCHEDULE OF NOTE DISCOUNT AMORTIZATIONEFFECTIVE-INTEREST METHOD

10% NOTE DISCOUNTED AT 12%

CarryingCash Interest Discount AmountPaid Expense Amortized of Note

Date of issue $ 9,520End of year 1 $1,000a $1,142b $142c 9,662d

End of year 2 1,000 1,159 159 9,821End of year 3 1,000 1,179 179 10,000

$3,000 $3,480 $480

a$10,000 � 10% � $1,000 c$1,142 � $1,000 � $142b$9,520 � 12% � $1,142 d$9,520 � $142 � $9,662

ILLUSTRATION 14-13Schedule of Note DiscountAmortization

Turtle Cove records interest expense at the end of the first year using the effective-interest method as follows.

Interest Expense ($7,721.80 � 9%) 694.96

Discount on Notes Payable 694.96

The total amount of the discount, $2,278.20 in this case, represents the expense thatTurtle Cove Company will incur on the note over the three years.

Interest-Bearing NotesThe zero-interest-bearing note above is an example of the extreme difference betweenthe stated rate and the effective rate. In many cases, the difference between these ratesis not so great.

Consider the example from Chapter 7 where Marie Co. issued for cash a $10,000,three-year note bearing interest at 10 percent to Morgan Corp. The market rate of in-terest for a note of similar risk is 12 percent. Illustration 7-12 (page 334) shows the timediagram depicting the cash flows and the computation of the present value of this note.In this case, because the effective rate of interest (12%) is greater than the stated rate(10%), the present value of the note is less than the face value. That is, the note is ex-changed at a discount. Marie Co. records the issuance of the note as follows.

Cash 9,520

Discount on Notes Payable 480


Marie Co. then amortizes the discount and recognizes interest expense annually usingthe effective-interest method. Illustration 14-13 shows the three-year discount amorti-zation and interest expense schedule.




Marie Co. records payment of the annual interest and amortization of the discountfor the first year as follows (amounts per amortization schedule).

Interest Expense 1,142

Discount on Notes Payable 142

Cash 1,000

When the present value exceeds the face value, Marie Co. exchanges the note at apremium. It does so by recording the premium as a credit and amortizing it using theeffective-interest method over the life of the note as annual reductions in the amountof interest expense recognized.

SPECIAL NOTES PAYABLE SITUATIONSNotes Issued for Property, Goods, or ServicesSometimes, companies may receive property, goods, or services in exchange for a notepayable. When exchanging the debt instrument for property, goods, or services in abargained transaction entered into at arm’s length, the stated interest rate is presumedto be fair unless:

1. No interest rate is stated, or2. The stated interest rate is unreasonable, or3. The stated face amount of the debt instrument is materially different from the cur-

rent cash sales price for the same or similar items or from the current fair value ofthe debt instrument.

In these circumstances the company measures the present value of the debt instrumentby the fair value of the property, goods, or services or by an amount that reasonablyapproximates the fair value of the note. [5] If there is no stated rate of interest, theamount of interest is the difference between the face amount of the note and the fairvalue of the property.

For example, assume that Scenic Development Company sells land having a cashsale price of $200,000 to Health Spa, Inc. In exchange for the land, Health Spa gives afive-year, $293,866, zero-interest-bearing note. The $200,000 cash sale price representsthe present value of the $293,866 note discounted at 8 percent for five years. Shouldboth parties record the transaction on the sale date at the face amount of the note, whichis $293,866? No—if they did, Health Spa’s Land account and Scenic’s sales would beoverstated by $93,866 (the interest for five years at an effective rate of 8 percent). Sim-ilarly, interest revenue to Scenic and interest expense to Health Spa for the five-yearperiod would be understated by $93,866.

Because the difference between the cash sale price of $200,000 and the $293,866 faceamount of the note represents interest at an effective rate of 8 percent, the companies’transaction is recorded at the exchange date as follows.

Health Spa, Inc. (Buyer) Scenic Development Company (Seller)

Land 200,000 Notes Receivable 293,866Discount on Notes Payable 93,866 Discount on Notes Rec. 93,866

Notes Payable 293,866 Sales 200,000

ILLUSTRATION 14-14Entries for Noncash NoteTransactions

During the five-year life of the note, Health Spa amortizes annually a portion ofthe discount of $93,866 as a charge to interest expense. Scenic Development records in-terest revenue totaling $93,866 over the five-year period by also amortizing the dis-count. The effective-interest method is required, unless the results obtained from usinganother method are not materially different from those that result from the effective-interest method.



Special Notes Payable Situations · 707

Choice of Interest RateIn note transactions, the effective or market interest rate is either evident or deter-minable by other factors involved in the exchange, such as the fair value of what isgiven or received. But, if a company cannot determine the fair value of the property,goods, services, or other rights, and if the note has no ready market, the problem ofdetermining the present value of the note is more difficult. To estimate the present valueof a note under such circumstances, a company must approximate an applicable inter-est rate that may differ from the stated interest rate. This process of interest-rate ap-proximation is called imputation, and the resulting interest rate is called an imputedinterest rate.

The prevailing rates for similar instruments of issuers with similar credit ratingsaffect the choice of a rate. Other factors such as restrictive covenants, collateral, paymentschedule, and the existing prime interest rate also play a part. Companies determinethe imputed interest rate when they issue a note; any subsequent changes in prevailinginterest rates are ignored.

To illustrate, assume that on December 31, 2010, Wunderlich Company issued apromissory note to Brown Interiors Company for architectural services. The note hasa face value of $550,000, a due date of December 31, 2015, and bears a stated interestrate of 2 percent, payable at the end of each year. Wunderlich cannot readily determinethe fair value of the architectural services, nor is the note readily marketable. On thebasis of Wunderlich’s credit rating, the absence of collateral, the prime interest rate atthat date, and the prevailing interest on Wunderlich’s other outstanding debt, the com-pany imputes an 8 percent interest rate as appropriate in this circumstance. Illustration14-15 shows the time diagram depicting both cash flows.

4n = 5

i = 8%

2 3 50 1

$11,000 Interest

$550,000 Principal

$11,000$11,000$11,000$11,000PVPV – OAOA

PVPVPV

PV – OA

ILLUSTRATION 14-15Time Diagram for Interest-Bearing Note

The present value of the note and the imputed fair value of the architectural ser-vices are determined as follows.

Face value of the note $550,000Present value of $550,000 due in 5 years at 8% interest payable

annually (Table 6-2); FV(PVF5,8%); ($550,000 � .68058) $374,319Present value of $11,000 interest payable annually for 5 years at 8%;

R(PVF-OA5,8%); ($11,000 � 3.99271) 43,920Present value of the note 418,239

Discount on notes payable $131,761

ILLUSTRATION 14-16Computation of ImputedFair Value and NoteDiscount

Wunderlich records issuance of the note in payment for the architectural servicesas follows.

December 31, 2010

Building (or Construction in Process) 418,239

Discount on Notes Payable 131,761





The five-year amortization schedule appears below.

SCHEDULE OF NOTE DISCOUNT AMORTIZATIONEFFECTIVE-INTEREST METHOD

2% NOTE DISCOUNTED AT 8% (IMPUTED)

Cash Interest CarryingPaid Expense Discount Amount

Date (2%) (8%) Amortized of Note

12/31/10 $418,23912/31/11 $11,000a $ 33,459b $ 22,459c 440,698d

12/31/12 11,000 35,256 24,256 464,95412/31/13 11,000 37,196 26,196 491,15012/31/14 11,000 39,292 28,292 519,44212/31/15 11,000 41,558e 30,558 550,000

$55,000 $186,761 $131,761

a$550,000 � 2% � $11,000 d$418,239 � $22,459 � $440,698b$418,239 � 8% � $33,459 e$3 adjustment to compensate for rounding.c$33,459 � $11,000 � $22,459

ILLUSTRATION 14-17Schedule of DiscountAmortization UsingImputed Interest Rate

Calculator Solution forthe Fair Value of Services:

*Difference due to rounding.

N

Inputs

5

I/YR 8

PV ?

PMT –11,000

FV –550,000

418,241*

Answer

Wunderlich records payment of the first year’s interest and amortization of the dis-count as follows.

December 31, 2011


Discount on Notes Payable 22,459

Cash 11,000

MORTGAGE NOTES PAYABLEThe most common form of long-term notes payable is a mortgage note payable. Amortgage note payable is a promissory note secured by a document called a mortgagethat pledges title to property as security for the loan. Individuals, proprietorships,and partnerships use mortgage notes payable more frequently than do corporations.(Corporations usually find that bond issues offer advantages in obtaining large loans.)

The borrower usually receives cash for the face amount of the mortgage note. Inthat case, the face amount of the note is the true liability, and no discount or premiumis involved. When the lender assesses “points,” however, the total amount received bythe borrower is less than the face amount of the note.13 Points raise the effective inter-est rate above the rate specified in the note. A point is 1 percent of the face of the note.

For example, assume that Harrick Co. borrows $1,000,000, signing a 20-year mort-gage note with a stated interest rate of 10.75 percent as part of the financing for a newplant. If Associated Savings demands 4 points to close the financing, Harrick will re-ceive 4 percent less than $1,000,000—or $960,000—but it will be obligated to repay theentire $1,000,000 at the rate of $10,150 per month. Because Harrick received only$960,000, and must repay $1,000,000, its effective interest rate is increased to approxi-mately 11.3 percent on the money actually borrowed.

On the balance sheet, Harrick should report the mortgage note payable as a liabil-ity using a title such as “Mortgage Notes Payable” or “Notes Payable—Secured,” witha brief disclosure of the property pledged in notes to the financial statements.

Mortgages may be payable in full at maturity or in installments over the life ofthe loan. If payable at maturity, Harrick classifies its mortgage payable as a long-term liability on the balance sheet until such time as the approaching maturity date

13Points, in mortgage financing, are analogous to the original issue discount of bonds.



Off-Balance-Sheet Financing · 709

warrants showing it as a current liability. If it is payable in installments, Harrick showsthe current installments due as current liabilities, with the remainder as a long-termliability.

Lenders have partially replaced the traditional fixed-rate mortgage with alterna-tive mortgage arrangements. Most lenders offer variable-rate mortgages (also calledfloating-rate or adjustable-rate mortgages) featuring interest rates tied to changes in thefluctuating market rate. Generally the variable-rate lenders adjust the interest rate ateither one- or three-year intervals, pegging the adjustments to changes in the primerate or the U.S. Treasury bond rate.

Reporting of long-term debt is one of the most controversial areas in financial report-ing. Because long-term debt has a significant impact on the cash flows of the company,reporting requirements must be substantive and informative. One problem is that thedefinition of a liability established in Concepts Statement No. 6 and the recognition crite-ria established in Concepts Statement No. 5 are sufficiently imprecise that some continueto argue that certain obligations need not be reported as debt.

OFF-BALANCE-SHEET FINANCINGWhat do Krispy Kreme, Cisco, Enron, and Adelphia Communications have incommon? They all have been accused of using off-balance-sheet financing to min-imize the reporting of debt on their balance sheets. Off-balance-sheet financingis an attempt to borrow monies in such a way to prevent recording the obliga-tions. It has become an issue of extreme importance. Many allege that Enron, inone of the largest corporate failures on record, hid a considerable amount of its debtoff the balance sheet. As a result, any company that uses off-balance-sheet financingtoday risks investors dumping their stock. Consequently (as discussed in the openingstory), their share price will suffer. Nevertheless, a considerable amount of off-balance-sheet financing continues to exist. As one writer noted, “The basic drives of humansare few: to get enough food, to find shelter, and to keep debt off the balance sheet.”

Different FormsOff-balance-sheet financing can take many different forms:

1. Non-Consolidated Subsidiary: Under GAAP, a parent company does not have toconsolidate a subsidiary company that is less than 50 percent owned. In such cases,the parent therefore does not report the assets and liabilities of the subsidiary. Allthe parent reports on its balance sheet is the investment in the subsidiary. As a re-sult, users of the financial statements may not understand that the subsidiary hasconsiderable debt for which the parent may ultimately be liable if the subsidiaryruns into financial difficulty.

2. Special Purpose Entity (SPE): A company creates a special purpose entity to per-form a special project. To illustrate, assume that Clarke Company decides to builda new factory. However, management does not want to report the plant or theborrowing used to fund the construction on its balance sheet. It therefore creates

SECTION 3 • REPORTI NG AN D ANALYZI NG LONG-TERM DEBT

Objective•7Explain the reporting of off-balance-sheet financing arrangements.




an SPE, the purpose of which is to build the plant. (This arrangement is called aproject financing arrangement.) The SPE finances and builds the plant. In return,Clarke guarantees that it or some outside party will purchase all the products pro-duced by the plant. (Some refer to this as a take-or-pay contract). As a result, Clarkemight not report the asset or liability on its books. The accounting rules in this areaare complex; we discuss the accounting for SPEs in Appendix 17B.

3. Operating Leases: Another way that companies keep debt off the balance sheet isby leasing. Instead of owning the assets, companies lease them. Again, by meetingcertain conditions, the company has to report only rent expense each period and toprovide note disclosure of the transaction. Note that SPEs often use leases to ac-complish off-balance-sheet treatment. We discuss accounting for lease transactionsextensively in Chapter 21.

RationaleWhy do companies engage in off-balance-sheet financing? A major reason is that manybelieve that removing debt enhances the quality of the balance sheet and permitscredit to be obtained more readily and at less cost.

Second, loan covenants often limit the amount of debt a company may have. As aresult, the company uses off-balance-sheet financing, because these types of commit-ments might not be considered in computing the debt limitation.

Third, some argue that the asset side of the balance sheet is severely understated.For example, companies that use LIFO costing for inventories and depreciate assets onan accelerated basis will often have carrying amounts for inventories and property,plant, and equipment that are much lower than their fair values. As an offset to theselower values, some believe that part of the debt does not have to be reported. In otherwords, if companies report assets at fair values, less pressure would undoubtedly ex-ist for off-balance-sheet financing arrangements.

Whether the arguments above have merit is debatable. The general idea of “out ofsight, out of mind” may not be true in accounting. Many users of financial statementsindicate that they factor these off-balance-sheet financing arrangements into their com-putations when assessing debt to equity relationships. Similarly, many loan covenantsalso attempt to account for these complex arrangements. Nevertheless, many compa-nies still believe that benefits will accrue if they omit certain obligations from the bal-ance sheet.

As a response to off-balance-sheet financing arrangements, the FASB has increaseddisclosure (note) requirements. This response is consistent with an “efficient markets”philosophy: the important question is not whether the presentation is off-balance-sheetor not, but whether the items are disclosed at all. In addition, the SEC, in response tothe Sarbanes-Oxley Act of 2002, now requires companies to provide related informa-tion in their management discussion and analysis sections. Specifically, companies mustdisclose (1) all contractual obligations in a tabular format and (2) contingent liabilitiesand commitments in either a textual or tabular format.14

We believe that recording more obligations on the balance sheet will enhancefinancial reporting. Given the problems with companies such as Enron, Dynegy,Williams Company, Adelphia Communications, and Calpine, and the Sarbanes-Oxley requirements, we expect that less off-balance-sheet financing will occur in thefuture.

14It is unlikely that the FASB will be able to stop all types of off-balance-sheet transactions.Financial engineering is the Holy Grail of Wall Street. Developing new financial instrumentsand arrangements to sell and market to customers is not only profitable, but also adds tothe prestige of the investment firms that create them. Thus, new financial products willcontinue to appear that will test the ability of the FASB to develop appropriate accountingstandards for them.



Presentation and Analysis of Long-Term Debt · 711

PRESENTATION AND ANALYSIS OF LONG-TERM DEBTPresentation of Long-Term DebtCompanies that have large amounts and numerous issues of long-term debt fre-quently report only one amount in the balance sheet, supported with commentsand schedules in the accompanying notes. Long-term debt that matures withinone year should be reported as a current liability, unless using noncurrent assetsto accomplish retirement. If the company plans to refinance debt, convert it intostock, or retire it from a bond retirement fund, it should continue to report the debtas noncurrent. However, the company should disclose the method it will use in itsliquidation. [6], [7]

Note disclosures generally indicate the nature of the liabilities, maturity dates, in-terest rates, call provisions, conversion privileges, restrictions imposed by the creditors,and assets designated or pledged as security. Companies should show any assetspledged as security for the debt in the assets section of the balance sheet. The fair value


The off-balance-sheet world is slowly but surely becoming more on-balance-sheet. New interpreta-tions on guarantees (discussed in Chapter 13) and variable interest entities (discussed in Appendix17B) are doing their part to increase the amount of debt reported on corporate balance sheets.

In addition, the SEC recently issued a rule that requires companies to disclose off-balance-sheet arrangements and contractual obligations that currently have, or are reasonably likely tohave, a material future effect on the companies’ financial condition. Companies now must includea tabular disclosure (following a prescribed format) in the management discussion and analysissection of the annual report. Presented below is Best Buy’s tabular disclosure of its contractualobligations.

OBLIGATED

Best Buy Co.Contractual Obligations

The following table presents information regarding our contractual obligations by fiscal year ($ in millions):

Payments due by period

Less than More thanContractual Obligations Total 1 year 1–3 years 3–5 years 5 years

Short-term debt obligations $ 41 $ 41 $ 0 $ 0 $ 0Long-term debt obligations 414 2 9 403 0Capital lease obligations 24 3 6 2 13Financing lease obligations 171 14 30 33 94Interest payments 208 25 38 33 112Operating lease obligations 6,668 741 1,387 1,224 3,316Purchase obligations 2,198 1,113 775 291 19Deferred compensation 75 — — — —

Total $9,799 $1,939 $2,245 $1,986 $3,554

Note: For additional information refer to Note 5, Debt; Note 8, Leases; and Note 12, Contingenciesand Commitments, in the Notes to Consolidated Financial Statements.

Enron’s abuse of off-balance-sheet financing to hide debt was shocking and inappropriate. Onesilver lining in the Enron debacle however is that the standard-setting bodies in the accounting pro-fession are now providing increased guidance on companies’ reporting of contractual obligations.We believe the new SEC rule which requires companies to report their obligations over a period oftime will be extremely useful to the investment community.

There is no comparable institution tothe SEC in international securitiesmarkets. As a result, many interna-tional companies (those not registeredwith the SEC) are not required to pro-vide disclosures such as those relatedto contractual obligations.

INTERNATIONALINSIGHT

Objective•8Indicate how to present and analyze long-term debt.




ILLUSTRATION 14-18Long-Term DebtDisclosure

Best Buy Co.(dollars in millions)

Mar. 3, Feb. 25,2007 2006

Total current assets $9,081 $7,985

Current liabilitiesAccounts payable $3,934 $3,234Unredeemed gift card liabilities 496 469Accrued compensation and related expenses 332 354Accrued liabilities 990 878Accrued income taxes 489 703Short-term debt 41 —Current portion of long-term debt 19 418

Total current liabilities 6,301 6,056

Long-term liabilities 443 373

Long-term debt 590 178

5. Debt (in part) Mar. 3, Feb. 25,2007 2006

Convertible subordinated debentures, unsecured, due 2022,interest rate 2.25% $402 $402

Financing lease obligations, due 2009 to 2023, interest rates ranging from3.0% to 6.5% 171 157

Capital lease obligations, due 2008 to 2026, interest rates ranging from1.8% to 8.0% 24 27

Other debt, due 2010, interest rate 8.8% 12 10

Total debt 609 596Less: Current portion (19) (418)

Total long-term debt $590 $178

Certain debt is secured by property and equipment with a net book value of $80 and $41 at March 3,2007, and February 25, 2006, respectively.

At March 3, 2007, the future maturities of long-term debt, including capitalized leases, consisted of thefollowing:

Fiscal Year

2008 $ 192009 182010 272011 182012 420Thereafter 107

$609

The fair value of debt approximated $683 and $693 at March 3, 2007, and February 25, 2006, respectively,based on the ask prices quoted from external sources, compared with carrying values of $650 and $596,respectively.

of the long-term debt should also be disclosed if it is practical to estimate fair value.Finally, companies must disclose future payments for sinking fund requirements andmaturity amounts of long-term debt during each of the next five years. These disclo-sures aid financial statement users in evaluating the amounts and timing of futurecash flows. Illustration 14-18 shows an example of the type of information providedfor Best Buy Co. Note that if the company has any off-balance-sheet financing, it mustprovide extensive note disclosure. [8]



Presentation and Analysis of Long-Term Debt · 713

Analysis of Long-Term DebtLong-term creditors and stockholders are interested in a company’s long-run solvency,particularly its ability to pay interest as it comes due and to repay the face value of thedebt at maturity. Debt to total assets and times interest earned are two ratios that pro-vide information about debt-paying ability and long-run solvency.

Debt to Total Assets RatioThe debt to total assets ratio measures the percentage of the total assets provided bycreditors. To compute it, divide total debt (both current and long-term liabilities) by to-tal assets, as Illustration 14-19 shows.

Debt to total assets �Total debt

Total assets

ILLUSTRATION 14-19Computation of Debt toTotal Assets Ratio

Times interest earned �Income before income taxes and interest expense

Interest expense

ILLUSTRATION 14-20Computation of TimesInterest Earned Ratio

Times interest earned �($1,377 � $752 � $31)

$31� 70 times

Debt to total assets �$7,369

$13,570� 54.3%

ILLUSTRATION 14-21Computation of Long-TermDebt Ratios for Best Buy

The higher the percentage of debt to total assets, the greater the risk that the com-pany may be unable to meet its maturing obligations.

Times Interest Earned RatioThe times interest earned ratio indicates the company’s ability to meet interest pay-ments as they come due. As shown in Illustration 14-20, it is computed by dividingincome before interest expense and income taxes by interest expense.

To illustrate these ratios, we use data from Best Buy’s 2007 annual report. Best Buyhas total liabilities of $7,369 million, total assets of $13,570 million, interest expenseof $31 million, income taxes of $752 million, and net income of $1,377 million. Wecompute Best Buy’s debt to total assets and times interest earned ratios as shown inIllustration 14-21.

Even though Best Buy has a relatively high debt to total assets percentage of54.3 percent, its interest coverage of 70 times indicates it can easily meet its inter-est payments as they come due.

You will want to read theCONVERGENCE CORNER on page 714For discussion of how international convergenceefforts relate to liabilities.



714

iGAAP and U.S. GAAP have similar definitions for liabilities. iGAAP related to reporting and recognition of lia-bilities is found in IAS 1 (“Presentation of Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities,and Contingent Assets”).

LIABILITIES

O N T H E H O R I Z O N

As indicated in the Convergence Corner for Chapter 2, the IASB and FASB are working on a conceptual frameworkproject, part of which will examine the definition of a liability. In addition, this project will address the differencein measurements used between iGAAP and U.S. GAAP for contingent liabilities. Also, in its project on businesscombinations, the IASB is considering changing it definition of a contingent asset to converge with U.S. GAAP.

A B O U T T H E N U M B E R S

As indicated, iGAAP and U.S. GAAP differ as the criteria to be usedin recording restructuring liabilities. The following disclosure by NestléGroup in its 2006 annual report reflects application of iGAAP to a re-structuring situation.

C O N V E R G E N C E C O R N E R

Notes to the Financial Statements

23 provisions (in part) (in millions of CHF)

Restructuring

At 1 January, 2006 950Provisions made in the period 437Amounts used (326)Unused amounts reversed (34)Modification—translation, consolidation 7

At 31 December, 2006 1,034

RestructuringRestructuring provisions arise from a number of projects across the Group.These include plans to optimise industrial manufacturing capacities byclosing inefficient production facilities and reorganising others, mainly inEurope. . . . Restructuring provisions are expected to result in future cashoutflows when implementing the plans (usually over the following two tothree years) and are consequently not discounted.

As indicated in the chapter, the establishment of restructuring li-abilities for future costs can be used as a “cookie jar” to manage netincome. That is, companies can set up a liability and related expensecharge in one period to reduce income and then reduce the liabilityin future periods to increase net income. For example, when Nestlémakes the following entry for the unused amounts reversed in 2006,it is able to increase its income by 34 million CHF.

Restructuring Liability 34

Gain from Reversal of Restructuring Liability 34

R E L E VA N T FA C T S

• Similar to U.S. practice, iGAAP requires that compa-nies present current and noncurrent liabilities on theface of the balance sheet, with current liabilities gen-erally presented in order of liquidity.

• Under iGAAP, the measurement of a provision relatedto a contingency is based on the best estimate of theexpenditure required to settle the obligation. If a rangeof estimates is predicted and no amount in the rangeis more likely than any other amount in the range, the“mid-point” of the range is used to measure the liability.In U.S GAAP, the minimum amount in a range is used.

• Both GAAPs prohibit the recognition of liabilities forfuture losses. However, iGAAP permits recognition of arestructuring liability, once a company has committedto a restructuring plan. U.S. GAAP has additional crite-ria (i.e., related to communicating the plan to employ-ees) before a restructuring liability can be established.

• iGAAP and U.S. GAAP are similar in the treatment of asset retirement obligations (AROs). However, therecognition criteria for an ARO are more stringent under U.S. GAAP: The ARO is not recognized unlessthere is a present legal obligation and the fair value ofthe obligation can be reasonably estimated.

• iGAAP and U.S. GAAP are similar in their treatmentof contingencies. However, the criteria for recognizingcontingent assets are less stringent in the U.S. UnderU.S. GAAP, contingent assets for insurance recoveriesare recognized if probable; iGAAP requires the recoverybe “virtually certain” before recognition of an asset ispermitted.

We are not implying that Nestlé is using its reserve in inappropriate ways. Our point is that less-stringent iGAAP rules for es-tablishing restructuring liabilities could be used as an earnings management tool.



Summary of Learning Objectives · 715

SUMMARY OF LEARNING OBJECTIVES

Describe the formal procedures associated with issuing long-term debt. Incurringlong-term debt is often a formal procedure. The bylaws of corporations usually requireapproval by the board of directors and the stockholders before corporations can issuebonds or can make other long-term debt arrangements. Generally, long-term debt hasvarious covenants or restrictions. The covenants and other terms of the agreement be-tween the borrower and the lender are stated in the bond indenture or note agreement.

Identify various types of bond issues. Various types of bond issues are: (1) Securedand unsecured bonds. (2) Term, serial, and callable bonds. (3) Convertible, commodity-backed, and deep-discount bonds. (4) Registered and bearer (coupon) bonds. (5) In-come and revenue bonds. The variety in the types of bonds results from attempts toattract capital from different investors and risk takers and to satisfy the cash flow needsof the issuers.

Describe the accounting valuation for bonds at date of issuance. The investment com-munity values a bond at the present value of its future cash flows, which consist of in-terest and principal. The rate used to compute the present value of these cash flows isthe interest rate that provides an acceptable return on an investment commensuratewith the issuer’s risk characteristics. The interest rate written in the terms of the bondindenture and ordinarily appearing on the bond certificate is the stated, coupon, ornominal rate. The issuer of the bonds sets the rate and expresses it as a percentage ofthe face value (also called the par value, principal amount, or maturity value) of thebonds. If the rate employed by the buyers differs from the stated rate, the present valueof the bonds computed by the buyers will differ from the face value of the bonds. Thedifference between the face value and the present value of the bonds is either a discountor premium.

Apply the methods of bond discount and premium amortization. The discount (pre-mium) is amortized and charged (credited) to interest expense over the life of the bonds.Amortization of a discount increases bond interest expense, and amortization of apremium decreases bond interest expense. The profession’s preferred procedure foramortization of a discount or premium is the effective-interest method. Under theeffective-interest method, (1) bond interest expense is computed by multiplying thecarrying value of the bonds at the beginning of the period by the effective-interest rate;then, (2) the bond discount or premium amortization is determined by comparing thebond interest expense with the interest to be paid.

Describe the accounting for the extinguishment of debt. At the time of reacquisitionof long-term debt, the unamortized premium or discount and any costs of issue appli-cable to the debt must be amortized up to the reacquisition date. The reacquisition priceis the amount paid on extinguishment or redemption before maturity, including anycall premium and expense of reacquisition. On any specified date, the net carryingamount of the debt is the amount payable at maturity, adjusted for unamortized pre-mium or discount and issue costs. Any excess of the net carrying amount over the reac-quisition price is a gain from extinguishment. The excess of the reacquisition price overthe net carrying amount is a loss from extinguishment. Gains and losses on extinguish-ments are recognized currently in income.

Explain the accounting for long-term notes payable. Accounting procedures fornotes and bonds are similar. Like a bond, a note is valued at the present value of itsexpected future interest and principal cash flows, with any discount or premium be-ing similarly amortized over the life of the note. Whenever the face amount of the notedoes not reasonably represent the present value of the consideration in the exchange,

•6

•5

•4

•3

•2

•1

KEY TERMS

bearer (coupon) bonds, 691

bond discount, 693bond indenture, 690bond premium, 693callable bonds, 691carrying value, 697commodity-backed

bonds, 691convertible bonds, 691debenture bonds, 691debt to total assets

ratio, 713deep-discount (zero-

interest debenture)bonds, 691

effective-interest method, 697

effective yield, or marketrate, 693

extinguishment of debt, 701

face, par, principal ormaturity value, 692

imputation, 707imputed interest rate, 707income bonds, 691long-term debt, 690long-term notes

payable, 703mortgage notes

payable, 708off-balance-sheet

financing, 709refunding, 702registered bonds, 691revenue bonds, 691secured bonds, 691serial bonds, 691special purpose entity

(SPE), 709stated, coupon, or

nominal rate, 692straight-line method, 695term bonds, 691times interest earned

ratio, 713zero-interest debenture

bonds, 691




a company must evaluate the entire arrangement in order to properly record the ex-change and the subsequent interest.

Explain the reporting of off-balance-sheet financing arrangements. Off-balance-sheetfinancing is an attempt to borrow funds in such a way to prevent recording obliga-tions. Examples of off-balance-sheet arrangements are (1) non-consolidated sub-sidiaries, (2) special purpose entities, and (3) operating leases.

Indicate how to present and analyze long-term debt. Companies that have largeamounts and numerous issues of long-term debt frequently report only one amount inthe balance sheet and support this with comments and schedules in the accompany-ing notes. Any assets pledged as security for the debt should be shown in the assetssection of the balance sheet. Long-term debt that matures within one year should bereported as a current liability, unless retirement is to be accomplished with other thancurrent assets. If a company plans to refinance the debt, convert it into stock, or retireit from a bond retirement fund, it should continue to report it as noncurrent, accom-panied with a note explaining the method it will use in the debt’s liquidation. Disclo-sure is required of future payments for sinking fund requirements and maturityamounts of long-term debt during each of the next five years. Debt to total assets andtimes interest earned are two ratios that provide information about debt-paying abil-ity and long-run solvency.

•8

•7

Practically every day, the Wall Street Journal runs a story about some company in finan-cial difficulty. Notable recent examples are Delphi, Northwest Airlines, and UnitedAirlines. In most troubled-debt situations, the creditor usually first recognizes a losson impairment. Subsequently, the creditor either modifies the terms of the loan or thedebtor settles the loan on terms unfavorable to the creditor. In unusual cases, the cred-itor forces the debtor into bankruptcy in order to ensure the highest possible collectionon the loan. Illustration 14A-1 shows this continuum.

A P P E N D I X 14A TROUBLED-DEBT RESTRUCTURINGS

ILLUSTRATION 14A-1Usual Progression inTroubled-Debt Situations

LoanImpairment

LoanOrigination

Modification ofTerms

Bankruptcy

To illustrate, consider the case of Huffy Corp., a name that adorned the firstbicycle of many American children. Before its bankruptcy, Huffy’s creditors likelyrecognized a loss on impairment. Subsequently, the creditors either modified theterms of the loan or settled it on terms unfavorable to the creditor. Finally, thecreditors forced Huffy into bankruptcy, and the suppliers received a 30 percent eq-uity stake in Huffy. These terms helped ensure the highest possible collection on theHuffy loan.



Appendix: Troubled-Debt Restructurings · 717

We discussed the accounting for loan impairments in Appendix 7B. The pur-pose of this appendix is to explain how creditors and debtors report informationin financial statements related to troubled-debt restructurings.

A troubled-debt restructuring occurs when a creditor “for economic or legalreasons related to the debtor’s financial difficulties grants a concession to the debtorthat it would not otherwise consider.” [9] Thus a troubled-debt restructuring does notapply to modifications of a debt obligation that reflect general economic conditionsleading to a reduced interest rate. Nor does it apply to the refunding of an old debtwith new debt having an effective interest rate approximately equal to that of similardebt issued by nontroubled debtors.

A troubled-debt restructuring involves one of two basic types of transactions:

1. Settlement of debt at less than its carrying amount.2. Continuation of debt with a modification of terms.

SETTLEMENT OF DEBTIn addition to using cash, settling a debt obligation can involve either a transfer of non-cash assets (real estate, receivables, or other assets) or the issuance of the debtor’s stock.In these situations, the creditor should account for the noncash assets or equity in-terest received at their fair value.

The debtor must determine the excess of the carrying amount of the payable overthe fair value of the assets or equity transferred (gain). Likewise, the creditor must de-termine the excess of the receivable over the fair value of those same assets or equityinterests transferred (loss). The debtor recognizes a gain equal to the amount of the ex-cess. The creditor normally charges the excess (loss) against Allowance for DoubtfulAccounts. In addition, the debtor recognizes a gain or loss on disposition of assets tothe extent that the fair value of those assets differs from their carrying amount (bookvalue).

Transfer of AssetsAssume that American City Bank loaned $20,000,000 to Union Mortgage Company.Union Mortgage, in turn, invested these monies in residential apartment buildings.However, because of low occupancy rates, it cannot meet its loan obligations. AmericanCity Bank agrees to accept from Union Mortgage real estate with a fair value of$16,000,000 in full settlement of the $20,000,000 loan obligation. The real estate has acarrying value of $21,000,000 on the books of Union Mortgage. American City Bank(creditor) records this transaction as follows.

Real Estate 16,000,000

Allowance for Doubtful Accounts 4,000,000

Note Receivable from Union Mortgage 20,000,000

The bank records the real estate at fair value. Further, it makes a charge to the Al-lowance for Doubtful Accounts to reflect the bad debt write-off.

Union Mortgage (debtor) records this transaction as follows.Note Payable to American City Bank 20,000,000

Loss on Disposition of Real Estate 5,000,000

Real Estate 21,000,000

Gain on Restructuring of Debt 4,000,000

Union Mortgage has a loss on the disposition of real estate in the amount of$5,000,000 (the difference between the $21,000,000 book value and the $16,000,000 fairvalue). It should show this as an ordinary loss on the income statement. In addition,it has a gain on restructuring of debt of $4,000,000 (the difference between the$20,000,000 carrying amount of the note payable and the $16,000,000 fair value of thereal estate).

Objective•9Describe the accounting for a debtrestructuring.




Granting of Equity InterestAssume that American City Bank agrees to accept from Union Mortgage 320,000 sharesof common stock ($10 par) that has a fair value of $16,000,000, in full settlement of the$20,000,000 loan obligation. American City Bank (creditor) records this transaction asfollows.

Investment 16,000,000


Note Receivable from Union Mortgage 20,000,000

It records the stock as an investment at the fair value at the date of restructure.Union Mortgage (debtor) records this transaction as follows.

Note Payable to American City Bank 20,000,000

Common Stock 3,200,000

Additional Paid-in Capital 12,800,000

Gain on Restructuring of Debt 4,000,000

It records the stock issued in the normal manner. It records the difference between thepar value and the fair value of the stock as additional paid-in capital.

MODIFICATION OF TERMSIn some cases, a debtor’s serious short-run cash flow problems will lead it to requestone or a combination of the following modifications:

1. Reduction of the stated interest rate.2. Extension of the maturity date of the face amount of the debt.3. Reduction of the face amount of the debt.4. Reduction or deferral of any accrued interest.

The creditor’s loss is based on expected cash flows discounted at the historical effec-tive rate of the loan. [10] The debtor calculates its gain based on undiscounted amounts.As a consequence, the gain recorded by the debtor will not equal the loss recorded bythe creditor under many circumstances.15

Two examples demonstrate the accounting for a troubled-debt restructuring bydebtors and creditors:

1. The debtor does not record a gain.2. The debtor does record a gain.

In both instances the creditor has a loss.

Example 1—No Gain for DebtorThis example demonstrates a restructuring in which the debtor records no gain.16 OnDecember 31, 2009, Morgan National Bank enters into a debt restructuring agreement

15In response to concerns expressed about this nonsymmetric treatment, the FASB statedthat it did not address debtor accounting because expansion of the scope of the statementwould delay its issuance. By basing the debtor calculation on undiscounted amounts, theamount of gain (if any) recognized by the debtor is reduced at the time the modification ofterms occurs. If fair value were used, the gain recognized would be greater. The result ofthis approach is to spread the unrecognized gain over the life of the new agreement. Webelieve that this accounting is inappropriate and hopefully will change as more fair valuemeasurements are introduced into the financial statements.16Note that the examples given for restructuring assume the creditor made no previousentries for impairment. In actuality it is likely that the creditor would have already made an entry when the loan initially became impaired. Restructuring would, therefore, simplyrequire an adjustment of the initial estimated bad debt by the creditor. Recall, however, thatthe debtor makes no entry upon impairment.




with Resorts Development Company, which is experiencing financial difficulties. Thebank restructures a $10,500,000 loan receivable issued at par (interest paid to date) by:

1. Reducing the principal obligation from $10,500,000 to $9,000,000;2. Extending the maturity date from December 31, 2009, to December 31, 2013; and3. Reducing the interest rate from 12% to 8%.

Debtor CalculationsThe total future cash flow, after restructuring of $11,880,000 ($9,000,000 of principalplus $2,880,000 of interest payments17), exceeds the total pre-restructuring carryingamount of the debt of $10,500,000. Consequently, the debtor records no gain normakes any adjustment to the carrying amount of the payable. As a result, ResortsDevelopment (debtor) makes no entry at the date of restructuring.

The debtor must compute a new effective interest rate in order to record interestexpense in future periods. The new effective interest rate equates the present value ofthe future cash flows specified by the new terms with the pre-restructuring carryingamount of the debt. In this case, Resorts Development computes the new rate by relat-ing the pre-restructure carrying amount ($10,500,000) to the total future cash flow($11,880,000). The rate necessary to discount the total future cash flow ($11,880,000), toa present value equal to the remaining balance ($10,500,000), is 3.46613%.18

On the basis of the effective rate of 3.46613%, the debtor prepares the scheduleshown in Illustration 14A-2.

17Total interest payments are: $9,000,000 � .08 � 4 years � $2,880,000.18An accurate interest rate i can be found by using the formulas given at the tops of Tables 6-2and 6-4 to set up the following equation.

(from Table 6-2) (from Table 6-4)

Solving algebraically for i, we find that i � 3.46613%.

$10,500,000 �1

(1 � i)4 � $9,000,000 �

1 �1

(1 � i)4

i� $720,000

RESORTS DEVELOPMENT CO. (DEBTOR)

Cash Interest Reduction of CarryingPaid Expense Carrying Amount of

Date (8%) (3.46613%) Amount Note

12/31/09 $10,500,00012/31/10 $ 720,000a $ 363,944b $ 356,056c 10,143,94412/31/11 720,000 351,602 368,398 9,775,54612/31/12 720,000 338,833 381,167 9,394,37912/31/13 720,000 325,621 394,379 9,000,000

$2,880,000 $1,380,000 $1,500,000

a$720,000 � $9,000,000 � .08b$363,944 � $10,500,000 � 3.46613%c$356,056 � $720,000 � $363,944

ILLUSTRATION 14A-2Schedule ShowingReduction of CarryingAmount of Note

Thus, on December 31, 2010 (date of first interest payment after restructure), thedebtor makes the following entry.

December 31, 2010



Cash 720,000

Calculator Solution forInterest Rate

N

Inputs

4

I/YR ?

PV 10,500,000

PMT –720,000

FV –9,000,000

3.466

Answer




The debtor makes a similar entry (except for different amounts for debits to NotesPayable and Interest Expense) each year until maturity. At maturity, Resorts Develop-ment makes the following entry.

December 31, 2013

Notes Payable 9,000,000

Cash 9,000,000

Creditor CalculationsMorgan National Bank (creditor) must calculate its loss based on the expected futurecash flows discounted at the historical effective rate of the loan. It calculates this lossas shown in Illustration 14A-3.

Pre-restructure carrying amount $10,500,000Present value of restructured cash flows:Present value of $9,000,000 due in 4 years

at 12%, interest payable annually (Table 6-2); FV(PVF4,12%); ($9,000,000 � .63552) $5,719,680

Present value of $720,000 interest payable annually for 4 years at 12% (Table 6-4); R(PVF-OA4,12%);($720,000 � 3.03735) 2,186,892

Present value of restructured cash flows 7,906,572

Loss on restructuring $ 2,593,428

ILLUSTRATION 14A-3Computation of Loss toCreditor on Restructuring

As a result, Morgan National Bank records bad debt expense as follows (assumingno establishment of an allowance balance from recognition of an impairment).

Bad Debt Expense 2,593,428


In subsequent periods, Morgan National Bank reports interest revenue based onthe historical effective rate. Illustration 14A-4 provides the following interest and amor-tization information.

MORGAN NATIONAL BANK (CREDITOR)

Cash Interest Increase of CarryingReceived Revenue Carrying Amount of

Date (8%) (12%) Amount Note

12/31/09 $7,906,57212/31/10 $ 720,000a $ 948,789b $ 228,789c 8,135,36112/31/11 720,000 976,243 256,243 8,391,60412/31/12 720,000 1,006,992 286,992 8,678,59612/31/13 720,000 1,041,404d 321,404d 9,000,000

Total $2,880,000 $3,973,428 $1,093,428

a$720,000 � $9,000,000 � .08b$948,789 � $7,906,572 � .12c$228,789 � $948,789 � $720,000d$28 adjustment to compensate for rounding.

ILLUSTRATION 14A-4Schedule of Interest andAmortization after DebtRestructuring

On December 31, 2010, Morgan National Bank makes the following entry.

December 31, 2010

Cash 720,000

Allowance for Doubtful Accounts 228,789

Interest Revenue 948,789




The creditor makes a similar entry (except for different amounts debited to Allowancefor Doubtful Accounts and credited to Interest Revenue) each year until maturity. Atmaturity, the company makes the following entry.

December 31, 2013

Cash 9,000,000


Notes Receivable 10,500,000

Example 2—Gain for DebtorIf the pre-restructure carrying amount exceeds the total future cash flows as a result ofa modification of the terms, the debtor records a gain. To illustrate, assume the facts inthe previous example except that Morgan National Bank reduces the principal to$7,000,000 (and extends the maturity date to December 31, 2013, and reduces the inter-est from 12% to 8%). The total future cash flow is now $9,240,000 ($7,000,000 of prin-cipal plus $2,240,000 of interest19), which is $1,260,000 ($10,500,000 � $9,240,000) lessthan the pre-restructure carrying amount of $10,500,000.

Under these circumstances, Resorts Development (debtor) reduces the carryingamount of its payable $1,260,000 and records a gain of $1,260,000. On the other hand,Morgan National Bank (creditor) debits its Bad Debt Expense for $4,350,444. Illustra-tion 14A-5 shows this computation.

Pre-restructure carrying amount $10,500,000Present value of restructured cash flows:Present value of $7,000,000 due in 4 years at 12%,

interest payable annually (Table 6-2); FV(PVF4,12%); ($7,000,000 � .63552) $4,448,640

Present value of $560,000 interest payable annually for 4 years at 12% (Table 6-4); R(PVF-OA4,12%);($560,000 � 3.03735) 1,700,916 6,149,556

Creditor’s loss on restructuring $ 4,350,444

ILLUSTRATION 14A-5Computation of Loss toCreditor on Restructuring

19Total interest payments are: $7,000,000 � .08 � 4 years � $2,240,000.

December 31, 2009 (date of restructure)

Resorts Development Co. (Debtor) Morgan National Bank (Creditor)

Notes Payable 1,260,000 Bad Debt Expense 4,350,444

Gain on Restructuring Allowance for Doubtful Accounts 4,350,444of Debt 1,260,000

ILLUSTRATION 14A-6Debtor and CreditorEntries to Record Gainand Loss on Note

Illustration 14A-6 shows the entries to record the gain and loss on the debtor’s andcreditor’s books at the date of restructure, December 31, 2009.

For Resorts Development (debtor), because the new carrying value of the note($10,500,000 � $1,260,000 � $9,240,000) equals the sum of the undiscounted cashflows ($9,240,000), the imputed interest rate is 0 percent. Consequently, all of the futurecash flows reduce the principal balance, and the company recognizes no interestexpense.

Morgan National reports the interest revenue in the same fashion as the previ-ous example—that is, using the historical effective interest rate applied toward thenewly discounted value of the note. Illustration 14A-7 (on page 722) shows interestcomputations.




The journal entries in Illustration 14A-8 demonstrate the accounting by debtor andcreditor for periodic interest payments and final principal payment.

MORGAN NATIONAL BANK (CREDITOR)

Cash Interest Increase in CarryingReceived Revenue Carrying Amount of

Date (8%) (12%) Amount Note

12/31/09 $6,149,55612/31/10 $ 560,000a $ 737,947b $177,947c 6,327,50312/31/11 560,000 759,300 199,300 6,526,80312/31/12 560,000 783,216 223,216 6,750,01912/31/13 560,000 809,981d 249,981d 7,000,000

Total $2,240,000 $3,090,444 $850,444

a$560,000 � $7,000,000 � .08b$737,947 � $6,149,556 � .12c$177,947 � $737,947 � $560,000d$21 adjustment to compensate for rounding.

ILLUSTRATION 14A-7Schedule of Interest andAmortization after DebtRestructuring

CONCLUDING REMARKSThe accounting for troubled debt is complex because the accounting standards allowfor use of different measurement standards to determine the loss or gain reported. Inaddition, the assets and liabilities reported are sometimes not stated at cost or fair value,but at amounts adjusted for certain events but not others. This cumbersome account-ing demonstrates the need for adoption of a comprehensive fair-value model for finan-cial instruments that is consistent with finance concepts for pricing these financialinstruments.

Resorts Development Co. (Debtor) Morgan National Bank (Creditor)

December 31, 2010 (date of first interest payment following restructure)

Notes Payable 560,000 Cash 560,000

Cash 560,000 Allowance for Doubtful Accounts 177,947

Interest Revenue 737,947

December 31, 2011, 2012, and 2013 (dates of 2nd, 3rd, and last interest payments)

(Debit and credit same accounts as 12/31/10using applicable amounts from appropriate amortization schedules.)

December 31, 2013 (date of principal payment)

Notes Payable 7,000,000 Cash 7,000,000

Cash 7,000,000 Allowance for Doubtful Accounts 3,500,000

Notes Receivable 10,500,000

ILLUSTRATION 14A-8Debtor and CreditorEntries to Record PeriodicInterest and FinalPrincipal Payments

SUMMARY OF LEARNING OBJECTIVE

Describe the accounting for a debt restructuring. There are two types of debt settle-ments: (1) transfer of noncash assets, and (2) granting of equity interest. Creditors anddebtors record losses and gains on settlements based on fair values. For accountingpurposes there are also two types of restructurings with continuation of debt withmodified terms: (1) the carrying amount of debt is less than the future cash flows, and(2) the carrying amount of debt exceeds the total future cash flows. Creditors recordlosses on these restructurings based on the expected future cash flows discounted at thehistorical effective interest rate. The debtor determines its gain based on undiscountedcash flows.

•9

KEY TERM

troubled-debtrestructuring, 717



FASB Codification · 723

FASB Codification References[1] FASB ASC 835-30-55-2. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the

Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 16.][2] FASB ASC 835-30-35-2. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the

Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 15.][3] FASB ASC 470-50-45. [Predecessor literature: “Rescission of FASB Statements No. 4, 44, and 64 and Technical

Corrections,” Statement of Accounting Standards No. 145 (Norwalk, Conn.: FASB, 2002).][4] FASB ASC 835-30-15-3. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the

Accounting Principles Board No. 21 (New York: AICPA, 1971).][5] FASB ASC 835-30-05-2. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the

Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 12.][6] FASB ASC 470-10-50-4. [Predecessor literature: “Balance Sheet Classification of Short-Term Obligations

Expected to Be Refinanced,” FASB Statement of Financial Accounting Standards No. 6 (Stamford, Conn.: FASB,1975), par. 15.]

[7] FASB ASC 505-10-50-3. [Predecessor literature: “Disclosure of Information about Capital Structure,” FASBStatement of Financial Accounting Standards No. 129 (Norwalk, Conn.: 1997), par. 4.]

[8] FASB ASC 470-10-50-1. [Predecessor literature: “Disclosure of Long-Term Obligations,” FASB Statement ofFinancial Accounting Standards No. 47 (Stamford, Conn.: 1981), par. 10.]

[9] FASB ASC 310-40-15-2. [Predecessor literature: “Accounting by Debtors and Creditors for Troubled DebtRestructurings,” FASB Statement No. 15 (Norwalk, Conn.: FASB, June, 1977), par. 1.]

[10] FASB ASC 310-10-35. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASBStatement No. 114, (Norwalk, Conn.: FASB, May 1993), par. 42.]

FASB CODIFICATION

ExercisesAccess the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. ProvideCodification references for your responses.

CE14-1 Access the glossary (Master Glossary) to answer the following.

(a) What does the term “callable obligation” mean?(b) What is an imputed interest rate?(c) What is a long-term obligation?(d) What is the definition of “effective interest rate”?

CE14-2 What guidance does the Codification provide on the disclosure of long-term obligations?

CE14-3 Describe how a company would classify debt that includes covenants. What conditions must exist inorder to depart from the normal rule?

CE14-4 A company proposes to include in its SEC registration statement a balance sheet showing its subordi-nate debt as a portion of stockholders’ equity. Will the SEC allow this? Why or why not?

An additional Codification case can be found in the Using Your Judgment section, on page 739.

Be sure to check the companion website for a Review and Analysis Exercise, with solution.

w

iley.com/col

leg

e/k

ieso




QUESTIONS

1. (a) From what sources might a corporation obtain fundsthrough long-term debt? (b) What is a bond indenture?What does it contain? (c) What is a mortgage?

2. Potlatch Corporation has issued various types of bondssuch as term bonds, income bonds, and debentures. Differ-entiate between term bonds, mortgage bonds, collateraltrust bonds, debenture bonds, income bonds, callable bonds,registered bonds, bearer or coupon bonds, convertiblebonds, commodity-backed bonds, and deep discount bonds.

3. Distinguish between the following interest rates for bondspayable:

(a) yield rate (d) market rate

(b) nominal rate (e) effective rate

(c) stated rate

4. Distinguish between the following values relative tobonds payable:

(a) maturity value (c) market value

(b) face value (d) par value

5. Under what conditions of bond issuance does a discounton bonds payable arise? Under what conditions of bondissuance does a premium on bonds payable arise?

6. How should discount on bonds payable be reported onthe financial statements? Premium on bonds payable?

7. What are the two methods of amortizing discount and pre-mium on bonds payable? Explain each.

8. Zopf Company sells its bonds at a premium and appliesthe effective-interest method in amortizing the premium.Will the annual interest expense increase or decrease overthe life of the bonds? Explain.

9. Briggs and Stratton recently reported unamortized debtissue costs of $5.1 million. How should the costs of is-suing these bonds be accounted for and classified in thefinancial statements?

10. Will the amortization of Discount on Bonds Payable in-crease or decrease Bond Interest Expense? Explain.

11. What is the “call” feature of a bond issue? How does thecall feature affect the amortization of bond premium ordiscount?

12. Why would a company wish to reduce its bond indebt-edness before its bonds reach maturity? Indicate how thiscan be done and the correct accounting treatment for sucha transaction.

13. How are gains and losses from extinguishment of a debtclassified in the income statement? What disclosures arerequired of such transactions?

14. What is done to record properly a transaction involvingthe issuance of a non-interest-bearing long-term note inexchange for property?

15. How is the present value of a non-interest-bearing notecomputed?

16. When is the stated interest rate of a debt instrument pre-sumed to be fair?

17. What are the considerations in imputing an appropriateinterest rate?

18. Differentiate between a fixed-rate mortgage and avariable-rate mortgage.

19. What disclosures are required relative to long-term debtand sinking fund requirements?

20. What is off-balance-sheet financing? Why might a com-pany be interested in using off-balance-sheet financing?

21. What are some forms of off-balance-sheet financing?

22. Explain how a non-consolidated subsidiary can be a formof off-balance-sheet financing.

23. Where can authoritative iGAAP guidance related to lia-bilities be found?

24. Briefly describe some of the similarities and differencesbetween U.S. GAAP and iGAAP with respect to the ac-counting for liabilities.

25. Hong Kong Trading Co. (which uses iGAAP) is in themidst of a multi-year operational restructuring. It re-ported the following information in its 2010 annual report(amounts in $, in millions): Restructuring provision bal-ance at 1 January 2010, $135; provisions made in the pe-riod, $275; and unused amounts reversed, $22. Respondto the following: (a) What is the balance for the Restruc-turing Provision at 31 December 2010? (b) How did thereversal of unused amounts affect net income? (c) Brieflydiscuss how the accounting for the restructuring provi-sion can be used for earnings management.

26. Briefly discuss how accounting convergence efforts ad-dressing liabilities are related to the IASB/FASB concep-tual framework project.

*27. What are the types of situations that result in troubled debt?

*28. What are the general rules for measuring gain or loss byboth creditor and debtor in a troubled-debt restructuringinvolving a settlement?

*29. (a) In a troubled-debt situation, why might the creditorgrant concessions to the debtor?

(b) What type of concessions might a creditor grant thedebtor in a troubled-debt situation?

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendixto the chapter.



Brief Exercises · 725

BE14-1 Whiteside Corporation issues $500,000 of 9% bonds, due in 10 years, with interest payablesemiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price ofthe bonds.

BE14-2 The Colson Company issued $300,000 of 10% bonds on January 1, 2011. The bonds are due Jan-uary 1, 2016, with interest payable each July 1 and January 1. The bonds are issued at face value. PrepareColson’s journal entries for (a) the January issuance, (b) the July 1 interest payment, and (c) the Decem-ber 31 adjusting entry.

BE14-3 Assume the bonds in BE14-2 were issued at 98. Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31. Assume The Colson Company records straight-line amortization semi-annually.

BE14-4 Assume the bonds in BE14-2 were issued at 103. Prepare the journal entries for (a) January 1,(b) July 1, and (c) December 31. Assume The Colson Company records straight-line amortization semi-annually.

BE14-5 Devers Corporation issued $400,000 of 6% bonds on May 1, 2011. The bonds were datedJanuary 1, 2011, and mature January 1, 2013, with interest payable July 1 and January 1. The bonds wereissued at face value plus accrued interest. Prepare Devers’s journal entries for (a) the May 1 issuance,(b) the July 1 interest payment, and (c) the December 31 adjusting entry.

BE14-6 On January 1, 2011, JWS Corporation issued $600,000 of 7% bonds, due in 10 years. The bondswere issued for $559,224, and pay interest each July 1 and January 1. JWS uses the effective-interest method.Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and(c) the December 31 adjusting entry. Assume an effective interest rate of 8%.

BE14-7 Assume the bonds in BE14-6 were issued for $644,636 and the effective interest rate is 6%. Pre-pare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and(c) the December 31 adjusting entry.

BE14-8 Teton Corporation issued $600,000 of 7% bonds on November 1, 2011, for $644,636. The bondswere dated November 1, 2011, and mature in 10 years, with interest payable each May 1 and Novem-ber 1. Teton uses the effective-interest method with an effective rate of 6%. Prepare Teton’s December 31,2011, adjusting entry.

BE14-9 At December 31, 2011, Hyasaki Corporation has the following account balances:

Bonds payable, due January 1, 2019 $2,000,000Discount on bonds payable 88,000Bond interest payable 80,000

Show how the above accounts should be presented on the December 31, 2011, balance sheet, includingthe proper classifications.

BE14-10 Wasserman Corporation issued 10-year bonds on January 1, 2011. Costs associated with thebond issuance were $160,000. Wasserman uses the straight-line method to amortize bond issue costs.Prepare the December 31, 2011, entry to record 2011 bond issue cost amortization.

BE14-11 On January 1, 2011, Henderson Corporation retired $500,000 of bonds at 99. At the time ofretirement, the unamortized premium was $15,000 and unamortized bond issue costs were $5,250. Preparethe corporation’s journal entry to record the reacquisition of the bonds.

BE14-12 Coldwell, Inc. issued a $100,000, 4-year, 10% note at face value to Flint Hills Bank on January 1,2011, and received $100,000 cash. The note requires annual interest payments each December 31. PrepareColdwell’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment.

BRIEF EXERCISES

*30. What are the general rules for measuring and recogniz-ing gain or loss by both the debtor and the creditor in atroubled-debt restructuring involving a modification ofterms?

*31. What is meant by “accounting symmetry” between theentries recorded by the debtor and creditor in a troubled-

debt restructuring involving a modification of terms? Inwhat ways is the accounting for troubled-debt restruc-turings non-symmetrical?

*32. Under what circumstances would a transaction berecorded as a troubled-debt restructuring by only one ofthe two parties to the transaction?

•3

•4•3

•4•3

•4•3

•4•3

•4•3

•4•3

•4•3

•8

•4

•5

•6




BE14-13 Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company onJanuary 1, 2011, and received cash of $47,664. The implicit interest rate is 12%. Prepare Samson’s journalentries for (a) the January 1 issuance and (b) the December 31 recognition of interest.

BE14-14 McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on January 1,2011, and received a computer that normally sells for $31,495. The note requires annual interest pay-ments each December 31. The market rate of interest for a note of similar risk is 12%. Prepare McCormick’sjournal entries for (a) the January 1 issuance and (b) the December 31 interest.

BE14-15 Shlee Corporation issued a 4-year, $60,000, zero-interest-bearing note to Garcia Company onJanuary 1, 2011, and received cash of $60,000. In addition, Shlee agreed to sell merchandise to Garcia atan amount less than regular selling price over the 4-year period. The market rate of interest for similarnotes is 12%. Prepare Shlee Corporation’s January 1 journal entry.

E14-1 (Classification of Liabilities) Presented below are various account balances.

(a) Bank loans payable of a winery, due March 10, 2014. (The product requires aging for 5 years be-fore sale.)

(b) Unamortized premium on bonds payable, of which $3,000 will be amortized during the next year.(c) Serial bonds payable, $1,000,000, of which $250,000 are due each July 31.(d) Amounts withheld from employees’ wages for income taxes.(e) Notes payable due January 15, 2013.(f) Credit balances in customers’ accounts arising from returns and allowances after collection in full

of account.(g) Bonds payable of $2,000,000 maturing June 30, 2012.(h) Overdraft of $1,000 in a bank account. (No other balances are carried at this bank.)(i) Deposits made by customers who have ordered goods.

InstructionsIndicate whether each of the items above should be classified on December 31, 2011, as a current liabil-ity, a long-term liability, or under some other classification. Consider each one independently from allothers; that is, do not assume that all of them relate to one particular business. If the classification of someof the items is doubtful, explain why in each case.

E14-2 (Classification) The following items are found in the financial statements.

(a) Discount on bonds payable(b) Interest expense (credit balance)(c) Unamortized bond issue costs(d) Gain on repurchase of debt(e) Mortgage payable (payable in equal amounts over next 3 years)(f) Debenture bonds payable (maturing in 5 years)(g) Premium on bonds payable(h) Notes payable (due in 4 years)(i) Income bonds payable (due in 3 years)

InstructionsIndicate how each of these items should be classified in the financial statements.

E14-3 (Entries for Bond Transactions) Presented below are two independent situations.

1. On January 1, 2010, Divac Company issued $300,000 of 9%, 10-year bonds at par. Interest is payablequarterly on April 1, July 1, October 1, and January 1.

2. On June 1, 2010, Verbitsky Company issued $200,000 of 12%, 10-year bonds dated January 1 at parplus accrued interest. Interest is payable semiannually on July 1 and January 1.

InstructionsFor each of these two independent situations, prepare journal entries to record the following.

(a) The issuance of the bonds.(b) The payment of interest on July 1.(c) The accrual of interest on December 31.

EXERCISES

•6

•6

•6

•2

•2

•4•3



Exercises · 727

E14-4 (Entries for Bond Transactions—Straight-Line) Foreman Company issued $800,000 of 10%,20-year bonds on January 1, 2011, at 102. Interest is payable semiannually on July 1 and January 1.Foreman Company uses the straight-line method of amortization for bond premium or discount.

InstructionsPrepare the journal entries to record the following.

(a) The issuance of the bonds.(b) The payment of interest and the related amortization on July 1, 2011.(c) The accrual of interest and the related amortization on December 31, 2011.

E14-5 (Entries for Bond Transactions—Effective-Interest) Assume the same information as in E14-4,except that Foreman Company uses the effective-interest method of amortization for bond premium ordiscount. Assume an effective yield of 9.7705%.

InstructionsPrepare the journal entries to record the following. (Round to the nearest dollar.)

(a) The issuance of the bonds.(b) The payment of interest and related amortization on July 1, 2011.(c) The accrual of interest and the related amortization on December 31, 2011.

E14-6 (Amortization Schedules—Straight-Line) Spencer Company sells 10% bonds having a maturityvalue of $3,000,000 for $2,783,724. The bonds are dated January 1, 2010, and mature January 1, 2015.Interest is payable annually on January 1.

InstructionsSet up a schedule of interest expense and discount amortization under the straight-line method.

E14-7 (Amortization Schedule—Effective-Interest) Assume the same information as E14-6.

InstructionsSet up a schedule of interest expense and discount amortization under the effective-interest method.(Hint: The effective interest rate must be computed.)

E14-8 (Determine Proper Amounts in Account Balances) Presented below are three independent situations.

(a) Chinook Corporation incurred the following costs in connection with the issuance of bonds:(1) printing and engraving costs, $15,000; (2) legal fees, $49,000, and (3) commissions paid to un-derwriter, $60,000. What amount should be reported as Unamortized Bond Issue Costs, and whereshould this amount be reported on the balance sheet?

(b) McEntire Co. sold $2,500,000 of 10%, 10-year bonds at 104 on January 1, 2010. The bonds weredated January 1, 2010, and pay interest on July 1 and January 1. If McEntire uses the straight-linemethod to amortize bond premium or discount, determine the amount of interest expense to bereported on July 1, 2010, and December 31, 2010.

(c) Cheriel Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2010, for $562,500. This price pro-vided a yield of 10% on the bonds. Interest is payable semiannually on December 31 and June 30.If Cheriel uses the effective-interest method, determine the amount of interest expense to recordif financial statements are issued on October 31, 2010.

E14-9 (Entries and Questions for Bond Transactions) On June 30, 2010, Mackes Company issued$5,000,000 face value of 13%, 20-year bonds at $5,376,150, a yield of 12%. Mackes uses the effective-interestmethod to amortize bond premium or discount. The bonds pay semiannual interest on June 30 andDecember 31.

Instructions(a) Prepare the journal entries to record the following transactions.

(1) The issuance of the bonds on June 30, 2010.(2) The payment of interest and the amortization of the premium on December 31, 2010.(3) The payment of interest and the amortization of the premium on June 30, 2011.(4) The payment of interest and the amortization of the premium on December 31, 2011.

(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31,2011, balance sheet.

•4•3

•4•3

•4•3

•4•3

•4•3

•4•3




(c) Provide the answers to the following questions.(1) What amount of interest expense is reported for 2011?(2) Will the bond interest expense reported in 2011 be the same as, greater than, or less than the

amount that would be reported if the straight-line method of amortization were used?(3) Determine the total cost of borrowing over the life of the bond.(4) Will the total bond interest expense for the life of the bond be greater than, the same as, or

less than the total interest expense if the straight-line method of amortization were used?

E14-10 (Entries for Bond Transactions) On January 1, 2010, Osborn Company sold 12% bonds havinga maturity value of $800,000 for $860,651.79, which provides the bondholders with a 10% yield. The bondsare dated January 1, 2010, and mature January 1, 2015, with interest payable December 31 of each year.Osborn Company allocates interest and unamortized discount or premium on the effective interest basis.

Instructions(a) Prepare the journal entry at the date of the bond issuance.(b) Prepare a schedule of interest expense and bond amortization for 2010–2012.(c) Prepare the journal entry to record the interest payment and the amortization for 2010.(d) Prepare the journal entry to record the interest payment and the amortization for 2012.

E14-11 (Information Related to Various Bond Issues) Pawnee Inc. has issued three types of debt onJanuary 1, 2010, the start of the company’s fiscal year.

(a) $10 million, 10-year, 13% unsecured bonds, interest payable quarterly. Bonds were priced to yield 12%.(b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year.(c) $15 million, 10-year, 10% mortgage bonds, interest payable annually to yield 12%.

InstructionsPrepare a schedule that identifies the following items for each bond: (1) maturity value, (2) number of in-terest periods over life of bond, (3) stated rate per each interest period, (4) effective interest rate per eachinterest period, (5) payment amount per period, and (6) present value of bonds at date of issue.

E14-12 (Entry for Retirement of Bond; Bond Issue Costs) On January 2, 2005, Prebish Corporationissued $1,500,000 of 10% bonds at 97 due December 31, 2014. Legal and other costs of $24,000 were in-curred in connection with the issue. Interest on the bonds is payable annually each December 31. The$24,000 issue costs are being deferred and amortized on a straight-line basis over the 10-year term ofthe bonds. The discount on the bonds is also being amortized on a straight-line basis over the 10 years.(Straight-line is not materially different in effect from the preferable “interest method”.)

The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 2010, Prebish called$1,000,000 face amount of the bonds and retired them.

InstructionsIgnoring income taxes, compute the amount of loss, if any, to be recognized by Prebish as a result of re-tiring the $1,000,000 of bonds in 2010 and prepare the journal entry to record the retirement.

(AICPA adapted)

E14-13 (Entries for Retirement and Issuance of Bonds) Robinson, Inc. had outstanding $5,000,000 of11% bonds (interest payable July 31 and January 31) due in 10 years. On July 1, it issued $7,000,000 of10%, 15-year bonds (interest payable July 1 and January 1) at 98. A portion of the proceeds was used tocall the 11% bonds at 102 on August 1. Unamortized bond discount and issue cost applicable to the 11%bonds were $120,000 and $30,000, respectively.

InstructionsPrepare the journal entries necessary to record issue of the new bonds and the refunding of the bonds.

E14-14 (Entries for Retirement and Issuance of Bonds) On June 30, 2002, Mendenhal Companyissued 12% bonds with a par value of $600,000 due in 20 years. They were issued at 98 and were callableat 104 at any date after June 30, 2010. Because of lower interest rates and a significant change in the com-pany’s credit rating, it was decided to call the entire issue on June 30, 2011, and to issue new bonds. New10% bonds were sold in the amount of $800,000 at 102; they mature in 20 years. Mendenhal Companyuses straight-line amortization. Interest payment dates are December 31 and June 30.

Instructions(a) Prepare journal entries to record the retirement of the old issue and the sale of the new issue on

June 30, 2011.(b) Prepare the entry required on December 31, 2011, to record the payment of the first 6 months’ in-

terest and the amortization of premium on the bonds.

•4•3

•3

•5•4•3

•5•4•3

•5•4•3



Exercises · 729

E14-15 (Entries for Retirement and Issuance of Bonds) Friedman Company had bonds outstandingwith a maturity value of $500,000. On April 30, 2011, when these bonds had an unamortized discount of$10,000, they were called in at 104. To pay for these bonds, Friedman had issued other bonds a monthearlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bonds wereissued at 103 (face value $500,000). Issue costs related to the new bonds were $3,000.

InstructionsIgnoring interest, compute the gain or loss and record this refunding transaction.

(AICPA adapted)

E14-16 (Entries for Zero-Interest-Bearing Notes) On January 1, 2011, McLean Company makes thetwo following acquisitions.

1. Purchases land having a fair market value of $300,000 by issuing a 5-year, zero-interest-bearingpromissory note in the face amount of $505,518.

2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $400,000(interest payable annually).

The company has to pay 11% interest for funds from its bank.

Instructions(a) Record the two journal entries that should be recorded by McLean Company for the two purchases

on January 1, 2011.(b) Record the interest at the end of the first year on both notes using the effective-interest method.

E14-17 (Imputation of Interest) Presented below are two independent situations:

(a) On January 1, 2011, Spartan Inc. purchased land that had an assessed value of $390,000 at the timeof purchase. A $600,000, zero-interest-bearing note due January 1, 2014, was given in exchange.There was no established exchange price for the land, nor a ready market value for the note. Theinterest rate charged on a note of this type is 12%. Determine at what amount the land shouldbe recorded at January 1, 2011, and the interest expense to be reported in 2011 related to thistransaction.

(b) On January 1, 2011, Geimer Furniture Co. borrowed $4,000,000 (face value) from Aurora Co., amajor customer, through a zero-interest-bearing note due in 4 years. Because the note was zero-interest-bearing, Geimer Furniture agreed to sell furniture to this customer at lower than marketprice. A 10% rate of interest is normally charged on this type of loan. Prepare the journal entry torecord this transaction and determine the amount of interest expense to report for 2011.

E14-18 (Imputation of Interest with Right) On January 1, 2010, Durdil Co. borrowed and received$500,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As considera-tion for the zero-interest-bearing feature, Durdil agrees to supply the customer’s inventory needs for theloan period at lower than the market price. The appropriate rate at which to impute interest is 8%.

Instructions(a) Prepare the journal entry to record the initial transaction on January 1, 2010. (Round all compu-

tations to the nearest dollar.)(b) Prepare the journal entry to record any adjusting entries needed at December 31, 2010. Assume

that the sales of Durdil’s product to this customer occur evenly over the 3-year period.

E14-19 (Long-Term Debt Disclosure) At December 31, 2010, Redmond Company has outstanding threelong-term debt issues. The first is a $2,000,000 note payable which matures June 30, 2013. The second isa $6,000,000 bond issue which matures September 30, 2014. The third is a $12,500,000 sinking fund deben-ture with annual sinking fund payments of $2,500,000 in each of the years 2012 through 2016.

InstructionsPrepare the required note disclosure for the long-term debt at December 31, 2010.

*E14-20 (Settlement of Debt) Strickland Company owes $200,000 plus $18,000 of accrued interest toMoran State Bank. The debt is a 10-year, 10% note. During 2010, Strickland’s business deteriorated dueto a faltering regional economy. On December 31, 2010, Moran State Bank agrees to accept an old machineand cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, anda fair market value of $180,000.

Instructions(a) Prepare journal entries for Strickland Company and Moran State Bank to record this debt settlement.(b) How should Strickland report the gain or loss on the disposition of machine and on restructuring

of debt in its 2010 income statement?

•5•4•3

•6

•6

•6

•8

•9




(c) Assume that, instead of transferring the machine, Strickland decides to grant 15,000 shares of itscommon stock ($10 par) which has a fair value of $180,000 in full settlement of the loan obliga-tion. If Moran State Bank treats Strickland’s stock as a trading investment, prepare the entries torecord the transaction for both parties.

*E14-21 (Term Modification without Gain—Debtor’s Entries) On December 31, 2010, the AmericanBank enters into a debt restructuring agreement with Barkley Company, which is now experiencingfinancial trouble. The bank agrees to restructure a 12%, issued at par, $3,000,000 note receivable by thefollowing modifications:

1. Reducing the principal obligation from $3,000,000 to $2,400,000.2. Extending the maturity date from December 31, 2010, to January 1, 2014.3. Reducing the interest rate from 12% to 10%.

Barkley pays interest at the end of each year. On January 1, 2014, Barkley Company pays $2,400,000 incash to Firstar Bank.

Instructions(a) Will the gain recorded by Barkley be equal to the loss recorded by American Bank under the debt

restructuring?(b) Can Barkley Company record a gain under the term modification mentioned above? Explain.(c) Assuming that the interest rate Barkley should use to compute interest expense in future periods

is 1.4276%, prepare the interest payment schedule of the note for Barkley Company after the debtrestructuring.

(d) Prepare the interest payment entry for Barkley Company on December 31, 2012.(e) What entry should Barkley make on January 1, 2014?

*E14-22 (Term Modification without Gain—Creditor’s Entries) Using the same information as inE14-21 above, answer the following questions related to American Bank (creditor).

Instructions(a) What interest rate should American Bank use to calculate the loss on the debt restructuring?(b) Compute the loss that American Bank will suffer from the debt restructuring. Prepare the journal

entry to record the loss.(c) Prepare the interest receipt schedule for American Bank after the debt restructuring.(d) Prepare the interest receipt entry for American Bank on December 31, 2012.(e) What entry should American Bank make on January 1, 2014?

*E14-23 (Term Modification with Gain—Debtor’s Entries) Use the same information as in E14-21 aboveexcept that American Bank reduced the principal to $1,900,000 rather than $2,400,000. On January 1, 2014,Barkley pays $1,900,000 in cash to American Bank for the principal.

Instructions(a) Can Barkley Company record a gain under this term modification? If yes, compute the gain for

Barkley Company.(b) Prepare the journal entries to record the gain on Barkley’s books.(c) What interest rate should Barkley use to compute its interest expense in future periods? Will your

answer be the same as in E14-21 above? Why or why not?(d) Prepare the interest payment schedule of the note for Barkley Company after the debt restructuring.(e) Prepare the interest payment entries for Barkley Company on December 31, of 2011, 2012, and 2013.(f) What entry should Barkley make on January 1, 2014?

*E14-24 (Term Modification with Gain—Creditor’s Entries) Using the same information as in E14-21and E14-23 above, answer the following questions related to American Bank (creditor).

Instructions(a) Compute the loss American Bank will suffer under this new term modification. Prepare the journal

entry to record the loss on American’s books.(b) Prepare the interest receipt schedule for American Bank after the debt restructuring.(c) Prepare the interest receipt entry for American Bank on December 31, 2011, 2012, and 2013.(d) What entry should American Bank make on January 1, 2014?

*E14-25 (Debtor/Creditor Entries for Settlement of Troubled Debt) Gottlieb Co. owes $199,800 toCeballos Inc. The debt is a 10-year, 11% note. Because Gottlieb Co. is in financial trouble, Ceballos Inc.agrees to accept some property and cancel the entire debt. The property has a book value of $90,000 anda fair market value of $140,000.

•9

•9

•9

•9

•9



Problems · 731

Instructions(a) Prepare the journal entry on Gottlieb’s books for debt restructure.(b) Prepare the journal entry on Ceballos’s books for debt restructure.

*E14-26 (Debtor/Creditor Entries for Modification of Troubled Debt) Vargo Corp. owes $270,000 toFirst Trust. The debt is a 10-year, 12% note due December 31, 2010. Because Vargo Corp. is in financialtrouble, First Trust agrees to extend the maturity date to December 31, 2012, reduce the principal to$220,000, and reduce the interest rate to 5%, payable annually on December 31.

Instructions(a) Prepare the journal entries on Vargo’s books on December 31, 2010, 2011, 2012.(b) Prepare the journal entries on First Trust’s books on December 31, 2010, 2011, 2012.

•9

See the book’s companion website, www.wiley.com/college/kieso, for a set of B Exercises.

w

iley.com/col

leg

e/k

ieso

P14-1 (Analysis of Amortization Schedule and Interest Entries) The following amortization and in-terest schedule reflects the issuance of 10-year bonds by Capulet Corporation on January 1, 2004, and thesubsequent interest payments and charges. The company’s year-end is December 31, and financial state-ments are prepared once yearly.

Amortization Schedule

Amount BookYear Cash Interest Unamortized Value

1/1/2004 $5,651 $ 94,3492004 $11,000 $11,322 5,329 94,6712005 11,000 11,361 4,968 95,0322006 11,000 11,404 4,564 95,4362007 11,000 11,452 4,112 95,8882008 11,000 11,507 3,605 96,3952009 11,000 11,567 3,038 96,9622010 11,000 11,635 2,403 97,5972011 11,000 11,712 1,691 98,3092012 11,000 11,797 894 99,1062013 11,000 11,894 100,000

Instructions(a) Indicate whether the bonds were issued at a premium or a discount and how you can determine

this fact from the schedule.(b) Indicate whether the amortization schedule is based on the straight-line method or the effective-

interest method and how you can determine which method is used.(c) Determine the stated interest rate and the effective interest rate.(d) On the basis of the schedule above, prepare the journal entry to record the issuance of the bonds

on January 1, 2004.(e) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond trans-

actions and accruals for 2004. (Interest is paid January 1.)(f) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond trans-

actions and accruals for 2011. Capulet Corporation does not use reversing entries.

P14-2 (Issuance and Retirement of Bonds) Venzuela Co. is building a new hockey arena at a costof $2,500,000. It received a downpayment of $500,000 from local businesses to support the project, andnow needs to borrow $2,000,000 to complete the project. It therefore decides to issue $2,000,000 of 10.5%,10-year bonds. These bonds were issued on January 1, 2009, and pay interest annually on each Janu-ary 1. The bonds yield 10%. Venzuela paid $50,000 in bond issue costs related to the bond sale.

PROBLEMS

•4•3

•5•4•3




Instructions(a) Prepare the journal entry to record the issuance of the bonds and the related bond issue costs

incurred on January 1, 2009.(b) Prepare a bond amortization schedule up to and including January 1, 2013, using the effective-

interest method.(c) Assume that on July 1, 2012, Venzuela Co. retires half of the bonds at a cost of $1,065,000 plus

accrued interest. Prepare the journal entry to record this retirement.

P14-3 (Negative Amortization) Good-Deal Inc. developed a new sales gimmick to help sell itsinventory of new automobiles. Because many new car buyers need financing, Good-Deal offered a lowdown payment and low car payments for the first year after purchase. It believes that this promotion willbring in some new buyers.

On January 1, 2010, a customer purchased a new $33,000 automobile, making a downpayment of$1,000. The customer signed a note indicating that the annual rate of interest would be 8% and that quar-terly payments would be made over 3 years. For the first year, Good-Deal required a $400 quarterly paymentto be made on April 1, July 1, October 1, and January 1, 2011. After this one-year period, the customerwas required to make regular quarterly payments that would pay off the loan as of January 1, 2013.

Instructions(a) Prepare a note amortization schedule for the first year.(b) Indicate the amount the customer owes on the contract at the end of the first year.(c) Compute the amount of the new quarterly payments.(d) Prepare a note amortization schedule for these new payments for the next 2 years.(e) What do you think of the new sales promotion used by Good-Deal?

P14-4 (Issuance and Retirement of Bonds; Income Statement Presentation) Holiday Company issuedits 9%, 25-year mortgage bonds in the principal amount of $3,000,000 on January 2, 1996, at a discount of$150,000, which it proceeded to amortize by charges to expense over the life of the issue on a straight-line basis. The indenture securing the issue provided that the bonds could be called for redemption in to-tal but not in part at any time before maturity at 104% of the principal amount, but it did not provide forany sinking fund.

On December 18, 2010, the company issued its 11%, 20-year debenture bonds in the principal amountof $4,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2,2011. The indenture securing the new issue did not provide for any sinking fund or for retirement beforematurity.

Instructions(a) Prepare journal entries to record the issuance of the 11% bonds and the retirement of the 9% bonds.(b) Indicate the income statement treatment of the gain or loss from retirement and the note disclo-

sure required.

P14-5 (Comprehensive Bond Problem) In each of the following independent cases the company closesits books on December 31.

1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2010. The bonds pay interest on September 1and March 1. The due date of the bonds is September 1, 2013. The bonds yield 12%. Give entriesthrough December 31, 2011.

2. Titania Co. sells $400,000 of 12% bonds on June 1, 2010. The bonds pay interest on December 1 andJune 1. The due date of the bonds is June 1, 2014. The bonds yield 10%. On October 1, 2011, Titaniabuys back $120,000 worth of bonds for $126,000 (includes accrued interest). Give entries throughDecember 1, 2012.

Instructions(Round to the nearest dollar.)

For the two cases prepare all of the relevant journal entries from the time of sale until the date indicated.Use the effective-interest method for discount and premium amortization (construct amortization tableswhere applicable). Amortize premium or discount on interest dates and at year-end. (Assume that no re-versing entries were made.)

P14-6 (Issuance of Bonds between Interest Dates, Straight-Line, Retirement) Presented below areselected transactions on the books of Simonson Corporation.

May 1, 2010 Bonds payable with a par value of $900,000, which are dated January 1, 2010, are sold at106 plus accrued interest. They are coupon bonds, bear interest at 12% (payable annually atJanuary 1), and mature January 1, 2020. (Use interest expense account for accrued interest.)

•4•3

•5•4•3•8

•5•4•3

•5•4•3



Problems · 733

Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and theamortization of the proper amount of premium. (Use straight-line amortization.)

Jan. 1, 2011 Interest on the bonds is paid.April 1 Bonds of par value of $360,000 are called at 102 plus accrued interest, and retired. (Bond

premium is to be amortized only at the end of each year.)Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the proper

amount of premium amortized.

InstructionsPrepare journal entries for the transactions above.

P14-7 (Entries for Life Cycle of Bonds) On April 1, 2010, Seminole Company sold 15,000 of its 11%,15-year, $1,000 face value bonds at 97. Interest payment dates are April 1 and October 1, and the com-pany uses the straight-line method of bond discount amortization. On March 1, 2011, Seminole tookadvantage of favorable prices of its stock to extinguish 6,000 of the bonds by issuing 200,000 shares of its$10 par value common stock. At this time, the accrued interest was paid in cash. The company’s stockwas selling for $31 per share on March 1, 2011.

InstructionsPrepare the journal entries needed on the books of Seminole Company to record the following.

(a) April 1, 2010: issuance of the bonds.(b) October 1, 2010: payment of semiannual interest.(c) December 31, 2010: accrual of interest expense.(d) March 1, 2011: extinguishment of 6,000 bonds. (No reversing entries made.)

P14-8 (Entries for Zero-Interest-Bearing Note) On December 31, 2010, Faital Company acquired a com-puter from Plato Corporation by issuing a $600,000 zero-interest-bearing note, payable in full on Decem-ber 31, 2014. Faital Company’s credit rating permits it to borrow funds from its several lines of credit at10%. The computer is expected to have a 5-year life and a $70,000 salvage value.

Instructions(a) Prepare the journal entry for the purchase on December 31, 2010.(b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortiza-

tion (use effective-interest method) on December 31, 2011.(c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31,

2012.

P14-9 (Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis Cosmetics Co. pur-chased machinery on December 31, 2009, paying $50,000 down and agreeing to pay the balance in fourequal installments of $40,000 payable each December 31. An assumed interest of 8% is implicit in thepurchase price.

InstructionsPrepare the journal entries that would be recorded for the purchase and for the payments and interest onthe following dates.

(a) December 31, 2009. (d) December 31, 2012.(b) December 31, 2010. (e) December 31, 2013.(c) December 31, 2011.

P14-10 (Comprehensive Problem: Issuance, Classification, Reporting) Presented below are four in-dependent situations.

(a) On March 1, 2011, Wilke Co. issued at 103 plus accrued interest $4,000,000, 9% bonds. The bondsare dated January 1, 2011, and pay interest semiannually on July 1 and January 1. In addition,Wilke Co. incurred $27,000 of bond issuance costs. Compute the net amount of cash received byWilke Co. as a result of the issuance of these bonds.

(b) On January 1, 2010, Langley Co. issued 9% bonds with a face value of $700,000 for $656,992 toyield 10%. The bonds are dated January 1, 2010, and pay interest annually. What amount is re-ported for interest expense in 2010 related to these bonds, assuming that Langley used the effective-interest method for amortizing bond premium and discount?

•5•4•3

•6

•6

•5•4•3•8




(c) Tweedie Building Co. has a number of long-term bonds outstanding at December 31, 2010. Theselong-term bonds have the following sinking fund requirements and maturities for the next 6 years.

Sinking Fund Maturities

2011 $300,000 $100,0002012 100,000 250,0002013 100,000 100,0002014 200,000 —2015 200,000 150,0002016 200,000 100,000

Indicate how this information should be reported in the financial statements at December 31, 2010.(d) In the long-term debt structure of Beckford Inc., the following three bonds were reported: mort-

gage bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in installments,secured by plant equipment $4,000,000. Determine the total amount, if any, of debenture bondsoutstanding.

P14-11 (Effective-Interest Method) Samantha Cordelia, an intermediate accounting student, is havingdifficulty amortizing bond premiums and discounts using the effective-interest method. Furthermore, shecannot understand why GAAP requires that this method be used instead of the straight-line method. Shehas come to you with the following problem, looking for help.

On June 30, 2010, Hobart Company issued $2,000,000 face value of 11%, 20-year bonds at $2,171,600,a yield of 10%. Hobart Company uses the effective-interest method to amortize bond premiums ordiscounts. The bonds pay semiannual interest on June 30 and December 31. Compute the amortizationschedule for four periods.

InstructionsUsing the data above for illustrative purposes, write a short memo (1–1.5 pages double-spaced) toSamantha, explaining what the effective-interest method is, why it is preferable, and how it is computed.(Do not forget to include an amortization schedule, referring to it whenever necessary.)

*P14-12 (Debtor/Creditor Entries for Continuation of Troubled Debt) Daniel Perkins is the sole share-holder of Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a “debtor inpossession,” he has negotiated the following revised loan agreement with United Bank. Perkins Inc.’s$600,000, 12%, 10-year note was refinanced with a $600,000, 5%, 10-year note.

Instructions(a) What is the accounting nature of this transaction?(b) Prepare the journal entry to record this refinancing:

(1) On the books of Perkins Inc.(2) On the books of United Bank.

(c) Discuss whether generally accepted accounting principles provide the proper information usefulto managers and investors in this situation.

*P14-13 (Restructure of Note under Different Circumstances) Halvor Corporation is having financialdifficulty and therefore has asked Frontenac National Bank to restructure its $5 million note outstanding.The present note has 3 years remaining and pays a current rate of interest of 10%. The present marketrate for a loan of this nature is 12%. The note was issued at its face value.

InstructionsPresented below are four independent situations. Prepare the journal entry that Halvor and FrontenacNational Bank would make for each of these restructurings.

(a) Frontenac National Bank agrees to take an equity interest in Halvor by accepting common stockvalued at $3,700,000 in exchange for relinquishing its claim on this note. The common stock hasa par value of $1,700,000.

(b) Frontenac National Bank agrees to accept land in exchange for relinquishing its claim on this note.The land has a book value of $3,250,000 and a fair value of $4,000,000.

(c) Frontenac National Bank agrees to modify the terms of the note, indicating that Halvor does nothave to pay any interest on the note over the 3-year period.

(d) Frontenac National Bank agrees to reduce the principal balance due to $4,166,667 and requireinterest only in the second and third year at a rate of 10%.

•4

•9

•9



Concepts for Analysis · 735

*P14-14 (Debtor/Creditor Entries for Continuation of Troubled Debt with New Effective Interest)Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the amount of $330,000 plus $33,000 of ac-crued interest. The note is due today, December 31, 2010. Because Crocker Corp. is in financial trouble,D. Yaeger Corp. agrees to forgive the accrued interest, $30,000 of the principal, and to extend the matu-rity date to December 31, 2013. Interest at 10% of revised principal will continue to be due on 12/31 eachyear.

Assume the following present value factors for 3 periods.

21/4% 23/8% 21/2% 25/8% 23/4% 3%

Single sum .93543 .93201 .92859 .92521 .92184 .91514Ordinary annuity of 1 2.86989 2.86295 2.85602 2.84913 2.84226 2.82861

Instructions(a) Compute the new effective interest rate for Crocker Corp. following restructure. (Hint: Find the

interest rate that establishes approximately $363,000 as the present value of the total future cashflows.)

(b) Prepare a schedule of debt reduction and interest expense for the years 2010 through 2013.(c) Compute the gain or loss for D. Yaeger Corp. and prepare a schedule of receivable reduction and

interest revenue for the years 2010 through 2013.(d) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2010, 2011,

and 2012.(e) Prepare all the necessary journal entries on the books of D. Yaeger Corp. for the years 2010, 2011,

and 2012.

CA14-1 (Bond Theory: Balance Sheet Presentations, Interest Rate, Premium) On January 1, 2011,Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000and pay interest semiannually on January 1 and July 1. Bond issue costs were not material in amount.Below are three presentations of the long-term liability section of the balance sheet that might be used forthese bonds at the issue date.

1. Bonds payable (maturing January 1, 2031) $1,000,000Unamortized premium on bonds payable 85,800

Total bond liability $1,085,800

2. Bonds payable—principal (face value $1,000,000 maturingJanuary 1, 2031) $ 142,050a

Bonds payable—interest (semiannual payment $55,000) 943,750b


3. Bonds payable—principal (maturing January 1, 2031) $1,000,000Bonds payable—interest ($55,000 per period for 40 periods) 2,200,000


aThe present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period.bThe present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.

Instructions(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown

above for these bonds.(b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only

$1,000,000.(c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising

from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of us-ing for this purpose:(1) The coupon or nominal rate.(2) The effective or yield rate at date of issue.

(d) If the obligations arising from these bonds are to be carried at their present value computed bymeans of the current market rate of interest, how would the bond valuation at dates subsequentto the date of issue be affected by an increase or a decrease in the market rate of interest?

(AICPA adapted)

CONCEPTS FOR ANALYSIS

•9




CA14-2 (Various Long-Term Liability Conceptual Issues) Schrempf Company has completed a num-ber of transactions during 2010. In January the company purchased under contract a machine at a totalprice of $1,200,000, payable over 5 years with installments of $240,000 per year. The seller has consid-ered the transaction as an installment sale with the title transferring to Schrempf at the time of the finalpayment.

On March 1, 2010, Schrempf issued $10 million of general revenue bonds priced at 99 with a couponof 10% payable July 1 and January 1 of each of the next 10 years. The July 1 interest was paid and onDecember 30 the company transferred $1,000,000 to the trustee, Flagstad Company, for payment of theJanuary 1, 2011, interest.

As the accountant for Schrempf Company, you have prepared the balance sheet as of December 31,2010, and have presented it to the president of the company. You are asked the following questionsabout it.

1. Why has depreciation been charged on equipment being purchased under contract? Title has notpassed to the company as yet and, therefore, they are not our assets. Why should the company notshow on the left side of the balance sheet only the amount paid to date instead of showing the fullcontract price on the left side and the unpaid portion on the right side? After all, the seller consid-ers the transaction an installment sale.

2. What is bond discount? As a debit balance, why is it not classified among the assets?3. Bond interest is shown as a current liability. Did we not pay our trustee, Flagstad Company, the

full amount of interest due this period?

InstructionsOutline your answers to these questions by writing a brief paragraph that will justify your treatment.

CA14-3 (Bond Theory: Price, Presentation, and Retirement) On March 1, 2011, Sealy Company soldits 5-year, $1,000 face value, 9% bonds dated March 1, 2011, at an effective annual interest rate (yield) of11%. Interest is payable semiannually, and the first interest payment date is September 1, 2011. Sealy usesthe effective-interest method of amortization. Bond issue costs were incurred in preparing and selling thebond issue. The bonds can be called by Sealy at 101 at any time on or after March 1, 2012.

Instructions(a) (1) How would the selling price of the bond be determined?

(2) Specify how all items related to the bonds would be presented in a balance sheet preparedimmediately after the bond issue was sold.

(b) What items related to the bond issue would be included in Sealy’s 2011 income statement, andhow would each be determined?

(c) Would the amount of bond discount amortization using the effective-interest method of amorti-zation be lower in the second or third year of the life of the bond issue? Why?

(d) Assuming that the bonds were called in and retired on March 1, 2012, how should Sealy reportthe retirement of the bonds on the 2012 income statement?

(AICPA adapted)

CA14-4 (Bond Theory: Amortization and Gain or Loss Recognition)Part I. The appropriate method of amortizing a premium or discount on issuance of bonds is the effective-interest method.

Instructions(a) What is the effective-interest method of amortization and how is it different from and similar to

the straight-line method of amortization?(b) How is amortization computed using the effective-interest method, and why and how do amounts

obtained using the effective-interest method differ from amounts computed under the straight-line method?

Part II. Gains or losses from the early extinguishment of debt that is refunded can theoretically be ac-counted for in three ways:

1. Amortized over remaining life of old debt.2. Amortized over the life of the new debt issue.3. Recognized in the period of extinguishment.



Concepts for Analysis · 737

Instructions(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains

and losses from the early extinguishment of debt.(b) Which of the methods above is generally accepted and how should the appropriate amount of

gain or loss be shown in a company’s financial statements?(AICPA adapted)

CA14-5 (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in building its own sodacan manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to en-sure a steady supply of cans at a stable price and to minimize transportation costs. However, the com-pany has been experiencing some financial problems and has been reluctant to borrow any additionalcash to fund the project. The company is not concerned with the cash flow problems of making payments,but rather with the impact of adding additional long-term debt to its balance sheet.

The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company(ACC), their major supplier, to see if some agreement could be reached. ACC was anxious to work outan arrangement, since it seemed inevitable that Ryan would begin their own can production. The AluminumCan Company could not afford to lose the account.

After some discussion a two-part plan was worked out. First, ACC was to construct the plant onRyan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Un-der the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying aunit price which at normal capacity would cover labor and material, an operating management fee, andthe debt service requirements on the plant. The expected unit price, if transportation costs are taken intoconsideration, is lower than current market. If Ryan did not take enough production in any one year andif the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make upany cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 yearsthe plant is to become the property of Ryan.

Instructions(a) What are project financing arrangements using special purpose entities?(b) What are take-or-pay contracts?(c) Should Ryan record the plant as an asset together with the related obligation?(d) If not, should Ryan record an asset relating to the future commitment?(e) What is meant by off-balance-sheet financing?

CA14-6 (Bond Issue) Donald Lennon is the president, founder, and majority owner of Wichita MedicalCorporation, an emerging medical technology products company. Wichita is in dire need of additionalcapital to keep operating and to bring several promising products to final development, testing, and pro-duction. Donald, as owner of 51% of the outstanding stock, manages the company’s operations. He placesheavy emphasis on research and development and long-term growth. The other principal stockholder isNina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasizethe R & D functions and emphasize the marketing function to maximize short-run sales and profits fromexisting products. She believes this strategy would raise the market price of Wichita’s stock.

All of Donald’s personal capital and borrowing power is tied up in his 51% stock ownership. Heknows that any offering of additional shares of stock will dilute his controlling interest because he won’tbe able to participate in such an issuance. But, Nina has money and would likely buy enough shares togain control of Wichita. She then would dictate the company’s future direction, even if it meant replac-ing Donald as president and CEO.

The company already has considerable debt. Raising additional debt will be costly, will adverselyaffect Wichita’s credit rating, and will increase the company’s reported losses due to the growth in inter-est expense. Nina and the other minority stockholders express opposition to the assumption of additionaldebt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control andto preserve the direction of “his” company, Donald is doing everything to avoid a stock issuance and iscontemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.

Instructions(a) Who are the stakeholders in this situation?(b) What are the ethical issues in this case?(c) What would you do if you were Donald?




Financial Reporting ProblemThe Procter & Gamble Company (P&G)The financial statements of P&G are presented in Appendix 5B or can be accessed at the book’s compan-ion website, www.wiley.com/college/kieso.

Instructions

Refer to P&G’s financial statements and the accompanying notes to answer the following questions.(a) What cash outflow obligations related to the repayment of long-term debt does P&G have over the

next 5 years?(b) P&G indicates that it believes that it has the ability to meet business requirements in the foreseeable

future. Prepare an assessment of its liquidity, solvency, and financial flexibility using ratio analysis.

Comparative Analysis CaseThe Coca-Cola Company and PepsiCo, Inc.Instructions

Go to the book’s companion website and use information found there to answer the following questionsrelated to The Coca-Cola Company and PepsiCo, Inc.(a) Compute the debt to total assets ratio and the times interest earned ratio for these two companies.

Comment on the quality of these two ratios for both Coca-Cola and PepsiCo.(b) What is the difference between the fair value and the historical cost (carrying amount) of each com-

pany’s debt at year-end 2007? Why might a difference exist in these two amounts?(c) Both companies have debt issued in foreign countries. Speculate as to why these companies may use

foreign debt to finance their operations. What risks are involved in this strategy, and how might theyadjust for this risk?

Financial Statement Analysis CasesCase 1 Commonwealth Edison Co.The following article appeared in the Wall Street Journal.

Bond MarketsGiant Commonwealth Edison Issue Hits Resale Market With $70 Million Left OverNEW YORK—Commonwealth Edison Co.’s slow-selling new 91/4% bonds were tossed onto the resalemarket at a reduced price with about $70 million still available from the $200 million offered Thursday,dealers said.

The Chicago utility’s bonds, rated double-A by Moody’s and double-A-minus by Standard &Poor’s, originally had been priced at 99.803, to yield 9.3% in 5 years. They were marked down yes-terday the equivalent of about $5.50 for each $1,000 face amount, to about 99.25, where their yieldjumped to 9.45%.

Instructions

(a) How will the development above affect the accounting for Commonwealth Edison’s bond issue?(b) Provide several possible explanations for the markdown and the slow sale of Commonwealth

Edison’s bonds.

Case 2 PepsiCo, Inc.PepsiCo, Inc. based in Purchase, New York, is a leading company in the beverage industry.Assume that the following events occurred relating to PepsiCo’s long-term debt in a recent year.1. The company decided on February 1 to refinance $500 million in short-term 7.4% debt to make it

long-term 6%.2. $780 million of long-term zero-coupon bonds with an effective interest rate of 10.1% matured July 1

and were paid.3. On October 1, the company issued $250 million in Australian dollar 6.3% bonds at 102 and $95 mil-

lion in Italian lira 11.4% bonds at 99.

USING YOUR JUDGMENT

w

iley.com/col

leg

e/k

ieso

w

iley.com/col

leg

e/k

ieso



Using Your Judgment · 739

4. The company holds $100 million in perpetual foreign interest payment bonds that were issued in 1989,and presently have a rate of interest of 5.3%. These bonds are called perpetual because they have no stateddue date. Instead, at the end of every 10-year period after the bond’s issuance, the bondholders andPepsiCo have the option of redeeming the bonds. If either party desires to redeem the bonds, the bondsmust be redeemed. If the bonds are not redeemed, a new interest rate is set, based on the then-prevailinginterest rate for 10-year bonds. The company does not intend to cause redemption of the bonds, butwill reclassify this debt to current next year, since the bondholders could decide to redeem the bonds.

Instructions

(a) Consider event 1. What are some of the reasons the company may have decided to refinance thisshort-term debt, besides lowering the interest rate?

(b) What do you think are the benefits to the investor in purchasing zero-coupon bonds, such as thosedescribed in event 2? What journal entry would be required to record the payment of these bonds?If financial statements are prepared each December 31, in which year would the bonds have been in-cluded in short-term liabilities?

(c) Make the journal entry to record the bond issue described in event 3. Note that the bonds were is-sued on the same day, yet one was issued at a premium and the other at a discount. What are someof the reasons that this may have happened?

(d) What are the benefits to PepsiCo in having perpetual bonds as described in event 4? Suppose that inthe current year the bonds are not redeemed and the interest rate is adjusted to 6% from 7.5%. Makeall necessary journal entries to record the renewal of the bonds and the change in rate.

BRI DGE TO TH E PROFESSION

Professional Research: FASB CodificationWie Company has been operating for just 2 years, producing specialty golf equipment for women golfers.To date, the company has been able to finance its successful operations with investments from its princi-pal owner, Michelle Wie, and cash flows from operations. However, current expansion plans will requiresome borrowing to expand the company’s production line.

As part of the expansion plan, Wie will acquire some used equipment by signing a zero-interest-bearing note. The note has a maturity value of $50,000 and matures in 5 years. A reliable fair value mea-sure for the equipment is not available, given the age and specialty nature of the equipment. As a result,Wie’s accounting staff is unable to determine an established exchange price for recording the equipment(nor the interest rate to be used to record interest expense on the long-term note). They have asked youto conduct some accounting research on this topic.

Instructions

Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification ResearchSystem to prepare responses to the following items. Provide Codification references for your responses.(a) Identify the authoritative literature that provides guidance on the zero-interest-bearing note. Use

some of the examples to explain how the standard applies in this setting.(b) How is present value determined when an established exchange price is not determinable and a note

has no ready market? What is the resulting interest rate often called?(c) Where should a discount or premium appear in the financial statements? What about issue costs?

Professional SimulationGo to the book’s companion website, at www.wiley.com/college/kieso, to find an interactive problem thatsimulates the computerized CPA exam. The professional simulation for this chapter asks you to addressquestions related to the accounting for long-term liabilities.

KWW_Professional _Simulation

Time Remaining4 hours 30 minutes

©

donespliter?helpstandardssheetcalculatorpastecopy

Long-TermLiabilities

Remember to check the book’s companion website to find additional resources for this chapter.

wiley.com/c

olle

ge

/kie

so



Education

Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch14