Chapter 14 Bonds and LongTerm Notes Topics of

Chapter 14 Bonds and Long-Term Notes

Topics of Long-Term Liabilities n n n n Issuance of bonds (at a premium or discount) Fair value option of bonds Issuance of bonds between interest payment dates Extinguishment of debt Bonds issued with detachable stock warrants Convertible Bonds (including Induced Conversion) Long-term Notes Payable Troubled Debt Restructuring Long-Term Liabilities 2

Long-Term Liabilities n n Present value concept: Present value of $1 is the value today of $1 to be received at some future date, given a specific interest rate. Example: 1. What is the present value of $100 to be received a year from now given an annual market interest rate of 10%? P. V. (1+10%) = $100 P. V. = $100/1. 1 = $100 0. 9091 = $90. 91 Long-Term Liabilities 3

Long-Term Liabilities 2. What is the present value of $100 to be received two years from now given an annual interest rate of 10%? P. V (1+10%) = $100 P. V (1+10%)2 = $100 P. V. 1. 21 = $100 P. V. = $100 / 1. 21 = $100 0. 8264 = $82. 64 Long-Term Liabilities 4

Annuity: n Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods $100 $100 1 year n Receiving $100 every year for the following 5 years. (period = 1 year) (starting a year from now) Long-Term Liabilities 5

Present Value (P. V. ) of an Annuity: 1. Using the example above given a 10% Interest rate: P. V. of the first $100 = $100 0. 9091 = $90. 91 P. V. of the second $100 = $100 0. 8264 = $82. 64 P. V. of the third $100 = $100 0. 7513 = $75. 13 P. V. of the fourth $100 = $100 0. 6830 = $68. 30 P. V. of the fifth $100 = $100 0. 6209 = $62. 09 Total 3. 7907 $379. 07 Long-Term Liabilities 6

Present Value (P. V. ) of an Annuity (contd. ): n n n The P. V. of $100 annuity receiving every year for the following 5 years, starting a year from now => $100 * 3. 7907 = $379. 07 The P. V. of this annuity can be obtained from an annuity table under 10%, 5 periods. Long-Term Liabilities 7

Present Value (P. V. ) of an Annuity (contd. ): 2. What is the P. V. of $300 annuity receiving every 6 months for the following 30 months, starting 6 months from now ? The annual interest rate is 12%. P. V. = $300 x 4. 2124 = 1, 263. 7 Annuity Table, 5 periods at 6% (30/6=5) (12%/2=6%) Long-Term Liabilities 8

Corporate Bonds: n n n Bonds are securities issued by a corporation to borrow money from the public (many lenders). This is a source to raise funds. The corporation will receive cash when bonds are issued. Long-Term Liabilities 9

Corporate Bonds: n n The face value of the bonds must be repaid to the bondholders on the maturity date of the bonds. Also, the bond issuers will pay interests to the bondholders periodically (i. e. , semi -annually). Long-Term Liabilities 10

Bonds Payable n n Long-Term Liability: if bonds mature in more than one year. Short-Term Liability: if bonds mature in less than one year Long-Term Liabilities 11

Bond Indenture n n Bond Indenture is an agreement between the bond issuer and investors stating the following: u. Interest rate of bonds; u. Interest Payment dates; u. The maturity date of bonds; u The type of bonds: callable, convertible, . . The indenture is held by a trustee appointed by the issuing firm to represent the rights of the bondholders. Long-Term Liabilities 12

Bond Covenant • • • Bond Covenant is a contractual provision in a bond indenture (source: financial dictionary). Financial covenant: requiring issuers to maintain financial ratios such as debt/equity ratio and the interest coverage ratio at a certain level. Non-financial covenant: requiring the disclosure of certain financial information. Long-Term Liabilities 13

The Process of Bond Issuance 1. Receive the approval from the stockholders and regulatory authorities (i. e. , the SEC). 2. Print bond certificates and write indenture (to set the terms of bond issue such as the stated interest rate, the interest payment date and the maturity date…) 3. Make a public announcement of its intent to sell the bonds on a particular date. Long-Term Liabilities 14

The Process of Bond Issuance (cont. ) 4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i. e. , the stated inters rate), the general bond market conditions, the risk of the bonds and the expected state of the economy. Long-Term Liabilities 15

The Process of Bond Issuance (cont. ) 5. The underwriter will determine the effective interest rate (yield) and thus, the selling price that it believes best reflects the current market condition and the risk the bond for a particular bond issue. 6. The underwriter will either purchase the bonds from the issuing company and resell them to the public or sell these bonds for a commission. Long-Term Liabilities 16

The Process of Bond Issuance (cont. ) n n Companies can sell the entire issue of bonds to an underwriter or sell it to a single investor (i. e. , a pension fund) (referred to as a private placement). Any expenditures connected with a bond issue (legal fee, printing costs, accounting fee, underwriter's charges …) should be deferred and amortized as expense over the life of the bond using a straight line method. Long-Term Liabilities 17

The Process of Bond Issuance (Contd. ) n n The yield is the market rate (effective rate) for the bond issue. The yield is often different from the stated interest rate as a result of : 1) different opinion between the underwriter and the company, or 2) a change in the economic conditions between the date the terms were set and the date the bonds were issued. Long-Term Liabilities 18

The Process of Bond Issuance (Contd. ) Three possible outcomes of bond issuance: 1. Stated rate = effective rate => the bonds are sold at par 2. Stated rate < effective rate => bonds are sold at discount 3. Stated rate > effective rate => bonds are sold at premium Long-Term Liabilities 19

Units of bonds: n At $1, 000 or $5, 000 denominations n Price of bonds: stated at 100 s n Example: $1, 000 issued at 98 The issuing price is $1, 000 98 = $980 n Long-Term Liabilities 20

Types of bonds: On the basis whether the bonds are secured: u Secured Bonds u Unsecured Bonds (Debenture bonds) On the basis of how the interests are paid: u Registered Bonds u Coupon Bonds Long-Term Liabilities 21

Types of bonds: On the basis of how the bonds mature: u Term Bonds u Serial Bonds u Convertible Bonds u Callable Bonds Long-Term Liabilities 22

Asset-Backed Securities and Securitization of Assets • • Asset-backed securities: securities (i. e. , commercial paper, bonds) issued based on (or backed by) certain assets (i. e. , mortgage receivables). A conduit can be set up by a bank as an independent entity to take the title of financial assets (i. e. , mortgage or credit card receivables) of companies. Long-Term Liabilities 23

Asset-Backed Securities and Securitization of Assets (contd. ) • • The conduit issues securities (i. e. , commercial paper) backed by those financial assets. The cash generated from the sale of asset-backed securities goes back to the companies who put the assets into conduits. Source: ’Conduits’ in Need of a Fix by D. Reilly and C. Mollenkamp, WSJ , 8/30/2007 • As a result, those financial assets are securitized. Long-Term Liabilities 24

Bond Ratings (Source: Best. Vest Investments, Ltd) Moody' S&P s Aaa Aa A Baa Meaning Best quality, with the smallest amount of risk. AAA Issuers are extremely stable and dependable. High quality, with a slightly higher degree of AA long-term risk. A High to medium quality, with many strong attributes but with some risk exposure to changing economic conditions. Medium quality, currently adequate but with BBB significant risk possible over. Liabilities the long term. Long-Term 25

Bond Ratings (contd. ) Ba B Caa Ca BB B Some speculative element, with moderate security but not well safeguarded for the long haul. Able to pay now but with a significant risk of default in the future. CCC Poor quality with a clear danger of default. CC High speculative nature, often in or near default. C C Lowest rated, poor prospects of payment going forward but may be current in payments. -- D In default. Long-Term Liabilities 26

Determination of Bond Price n The obligations of bond issuers: (1) to pay the principal when bond matures on the maturity date. n (2) to pay interests periodically (i. e. , semiannually) over the life the bond. Present value of a bond: the present value of future net cash flows related to the bond using the effective interest rate. Long-Term Liabilities 27

Determination of Bond Price (Contd. ) n n Bond Price = the present value of the bond. Present value of bonds => The sum of (1) the present value of the principal plus (2) the present value of the periodic interests using the effective interest rate (not the stated interest rate) as the discount rate. Long-Term Liabilities 28

Determination of Bond Price (Contd. ) Discount rate = effective rate = market rate =yield u This rate depends on the riskiness of the issuer, the general state of the economy, the duration of the bond, etc. n In general, a higher risk will result in a higher effective rate. n Long-Term Liabilities 29

Determination of Bond Price (Contd. ) n Bonds Issued at Face Value When the stated interest rate equals the effective interest rate, the bond price will equal the face value. Long-Term Liabilities 30

Determination of Bond Price (Contd. ) Example 1: Page company issued a 5 -year term bond with a face amount $100, 000 and a stated annual interest rate of 10%. Interests are paid semiannually. Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)? n Long-Term Liabilities 31

Determination of Bond Price (Contd. ) (1)P. V. of the principal ($100, 000 mature in 5 years, discount rate 5%, 10 periods): The annual effective rate = 10% (10%/2= 5%) $100, 000 0. 6139 = $61, 390 (2)P. V. of the interests received semiannually for 10 periods (annuity, discount rate = 5%, 10 periods) $5, 000 7. 7217 = 38, 608. 5 annuity table, 5%, 10 periods Long-Term Liabilities 32

Determination of Bond Price (Contd. ) n The P. V. of the bond = the sum of (1) and (2) (1) + (2) = $61, 390 + 38, 608. 5 = $100, 000 Note: The semiannual interest paid = $100, 000 5% = $5, 000 the annual stated interest rate, not the effective rate!! Long-Term Liabilities 33

Determination of Bond Price (Contd. ) n Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P. V. of bonds) equals the face value. J. E. (when bonds are issued at face value) Cash 100, 000 Bonds payable 100, 000 Long-Term Liabilities 34

Bond Issued at A Discount n n When the stated interest rate is less than the effective interest rate, the present value of a bond will be less than its face value. Example 2: Use the same example as on page 28, except that the effective rate is 12%, rather than 10% to compute the present value of the bond. Long-Term Liabilities 35

Bond Issued at A Discount (Contd. ) n Since the interests are paid semiannually, the discount rate is 6% with 10 periods. (1)P. V. of the principal = $100, 000 . 5584 = $55, 840 P. V. table, 6%, 10 periods (2) P. V. of the semiannual interest: $5, 000 7. 3601 = 36, 800. 5 Annuity table, 6%, 10 periods P. V. of the bond = (1) + (2) $55, 840 + 36, 800. 5 = $92, 640. 5 Long-Term Liabilities 36

Bond Issued at A Discount (Contd. ) n $92, 640. 5 < $100, 000 (Discount = $7359. 5) P. V. of bond < Face vale => when the stated rate is less than the effective rate (i. e. , 10% < 12%), the P. V. of the bond will be less than the face value. n J. E. (when bonds are issued at discount) Cash 92, 640. 5 Discount on Bonds 7, 359. 5 Bonds Payable 100, 000 Long-Term Liabilities 37

Bond Issued at A Discount (Contd. ) Question: What is the total interest expense of this bond (issued at Discount)? Cash payment by the issuer ($150, 000) Cash received from issuing the bond (at Discount) 92, 640. 5 Interest Expense $57, 359. 50* n Long-Term Liabilities 38

Bond Issued at A Premium n n When the stated interest rate is higher than the effective interest rate demanded by the investors for the level of the risk of the bonds, the present value of the bonds would be greater than its face value. Example 3: use the same example as on page 26, except that the effective interest rate is 8%. (the stated interest rate is still at 10%) Long-Term Liabilities 39

Bond Issued at A Premium (Contd. ) n Compute the P. V. of the bond: Since the interests are paid semiannually, the discount rate would be 4% and the discounting periods are 10 periods. (1) P. V. of the principal: $100, 000 x 0. 6756 = $67, 560 Long-Term Liabilities 40

Bond Issued at A Premium (Contd. ) (2) P. V. of the semiannual interest: $5, 000 x 8. 1109 = $40, 554. 5 P. V. of the bond = (1) + (2) = $67, 560 + 40, 554. 5 = $108, 114. 5 > $100, 000 (Premium = 8, 114. 5) Long-Term Liabilities 41

Bond Issued at A Premium (Contd. ) Example 3 J. E. (When Bonds are issued at Premium) Cash 108, 114. 5 Bonds Payable 100, 000 Premium on Bonds Payable 8, 114. 50 n Long-Term Liabilities 42

Bond Issued at A Premium (Contd. ) n Interest Expense= interest payments - Premium = $5, 000 x 10 - 8, 114. 5 = $41, 885. 5 (Premium will decrease the interest expense. ) Long-Term Liabilities 43

Bond Issued at A Premium (Contd. ) n n A premium account: an adjunct account to the bonds payable account and is shown as an addition to the bonds payable account. A discount account: a contra account to the bonds payable and is shown as a deduction from the bonds payable. Long-Term Liabilities 44

Bond Issued at A Premium (Contd. ) n n Book value (carrying value) of the bond issued: the face value minus any unamortized discounts or plus any unamortized premiums. If an effective interest method is used to amortize the discount (or premium), the book value equals the present value when the effective interest rate remains unchanged. Long-Term Liabilities 45

Accounting for Bonds Payable Bonds Are Issued at Par n The information of example 1 on page 28 is summarized below with some additional information: Issuing Company: Page Company Stated Interest: 10% (annual) Effective Interest: 10% (annual) Date of Issuance: 2/1/x 2 Date of Maturity: 2/1/x 7 Interest Payment Dates: 2/1 and 8/1 Face Value: $100, 000 P. V. of the Bond: $100, 000 Long-Term Liabilities 46

Accounting for Bonds Payable Bonds Are Issued at Par (Contd. ) n J. E. 2/1/x 2 8/1/x 2 Cash B/P Interest Expense Cash 100, 000 5, 000 12/31/x 2 Adjusting entry for 5 -month interest expense occurred but not paid. The interest payment dates are 2/1 and 8/1). Interest Expense 4, 167 Interest payable 4, 167 Long-Term Liabilities 47

Accounting for Bonds Payable Bonds Are Issued at Par (Contd. ) n (Reversing Entry) 1/1/x 3 Interest Payable 4, 167 Interest Expense 4, 167 2/1/x 3 Interest Expense 5, 000 Cash 5, 000 (If no reversing entry recorded on 1/1/x 3, the J. E. of 2/1/x 3 would be: Interest Expense 833 Interest Payable 4, 167 Cash 5, 000 Long-Term Liabilities 48

Accounting for Bonds Payable Bonds Are Issued at Par (Contd. ) 8/1/x 3 Interest Expense 5, 000 Cash 5, 000 12/31/x 3 n Adjusting entry for the 5 -month unrecorded interest expense Interest Expense 4, 167 Interest payable 4, 167 Long-Term Liabilities 49

Accounting for Bonds Payable Bonds Are Issued at Par (Contd. ) n n n n 1/1/x 4 Reversing Entry 2/1/x 4 (Interest payment) 8/1/x 4 (Interest payment) 12/31/x 4 (Adjusting) 1/1/x 5 (Reversing) : 12/31/x 6 (Adjusting) 1/1/x 7 (Reversing) 2/1/x 7 Interest Expense 5, 000 Cash Bonds Payable 100, 000 cash (Bond Retirements at Maturity) Long-Term Liabilities 5, 000 100, 000 50

Accounting for Bonds Payable Bonds Are Issued at A Discount n n n n Information of example 2 is summarized below with some additional information: Stated Interest = 10% (annual) Effective Interest = 12% (annual) Date of Issuance = 1/1/x 2 (sold on 1/1/x 2) Date of Maturity = 1/1/x 7 Interest Payment Dates = 6/30 and 12/31 Face Value = $100, 000 P. V. of the Bond = 92, 640. 50 (as computed earlier) Long-Term Liabilities 51

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) n n n Discount = $100, 000 - 92, 640. 5 = 7, 359. 50 This discount would increase the interest expense and would be amortized over the life of the bond -5 year, 10 periods) Amortization methods: 1. Straight-Line: the Discount would be amortized equally over the life of the bond. i. e. , Amortization in 10 periods: $7349. 50 10 = $735. 95 Therefore, the interest expense every period is $5, 000 + 7, 35. 95 = $5, 735. 95 Semiannual Interest Payment the amortized Discount Long-Term Liabilities 52

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) n Total Interest expense = 5, 735. 95 x 10 = $5, 7359. 5 = 50, 000 + 7, 359. 5 Int. payment Discount 2. Effective Interest Method Interest Expense = P. V. of Bond effective rate Long-Term Liabilities 53

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) J. E (Bonds are issued at a discount and use the straight-line method to amortize the discount) 1/1/x 2 Cash 92640. 50 Discount on B/P 7359. 50 B/P 100, 000 6/30/x 2 Interest Expense 5, 736 Cash 5000* Discount on B/P 735. 95** 12/31/x 2 Interest Expense 5, 736 Cash 5, 000 Discount on B/P 735. 95 n Long-Term Liabilities 54

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) * Interest Payment = semiannual interest = $100, 000 x 10% x 1/2 ** Amortization of Discount over 10 periods (7359. 50/10) ***Interest Expense = Interest Payment Amortized Discount. 6/30/x 3 Same J. E. as recorded on 6/30/x 2 12/31/x 3 Same J. E. as recorded on 6/30/x 2 6/30/x 4 Same J. E. as recorded on 6/30/x 2 12/31/x 4 Same J. E. as recorded on 6/30/x 2 6/30/x 5 Same J. E. as recorded on 6/30/x 2 12/31/x 5 Same J. E. as recorded on 6/30/x 2 6/30/x 6 Same J. E. as recorded on 6/30/x 2 12/31/x 6 Same J. E. as recorded on 6/30/x 2 Long-Term Liabilities 55

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) 12/31/x 6 Interest Expense 5, 736 Cash 5, 000 Discount on Bonds Payable 735. 95 1/1/x 7 B/P 100, 000 Cash 100, 000 Discount on Bonds 1/1/x 2 7, 359. 50 Interest Expense from 1/1/x 2 to 12/31/x 6 735. 95 6/30/x 2 = $ 5, 735. 95 * 10 735. 95 12/31/x 2 = $5, 7, 359. 50 735. 95 6/30/x 3 = $50, 000 + 7, 359. 5 735. 95 12/31/x 6 Interest Discount on payments Bonds Long-Term Liabilities 56

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) n n J. E. for bonds issued at a discount and use the effective interest method to amortize the discount: using the example on p. 48. Interest Payment = $100, 000 * 5%= $5, 000 Interest Expense = P. V. of Bond at the Beginning of the period Effective Rate Amortized Discount = Interest Expense Interest payment Long-Term Liabilities 57

Effective Interest Amortization Table-bond are issued at a discount Long-Term Liabilities 58

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) J. E : 1/1/x 2 Cash Discount on B/P 6/30/x 2 Interest Expense (period 1) Cash Discount on B/P 12/31/x 2 Interest Expense (period 2) Cash Discount on B/P n 92, 641 7, 359 100, 000 5, 558 5, 000 558 5, 592 5, 000 592 Long-Term Liabilities 59

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) 6/30/x 3 Interest Expense Cash Discount on B/ P : : 6/30/x 6 Interest Expense Cash Discount on B/P 12/31/x 6 Interest Expense Cash Discount on B/P 1/1/x 7 B/P Cash Long-Term Liabilities 5, 672 5, 890 5, 944 5, 000 672 5, 000 890 5, 000 944 100, 000 60

Accounting for Bonds Payable Bonds Are Issued at A Discount (Contd. ) Discount on Bonds Payable Interest Expense over 10 1/1/x 2 7, 359 558… 6/30/x 2 periods => Period 1 $5, 558 592… 12/31/x 2 Period 2 $5, 592 672… 6/30/x 3 period 3 $5, 627 890… 6/30/x 6 Period 9 $ 5, 890 Period 10 $ 5, 944… 12/31/x 6 0 $57, 359 $57360= $50, 000 + 7, 359 Long-Term Liabilities 61

Accounting for Bonds Payable (Contd. ) n n APB Opinion 21 requires the use of the effective interest method for the amortization of premium or discount when two amortization methods generate significant different result. APB opinion 21 also requires the separate recording of premiums and discounts. Long-Term Liabilities 62

Book Value vs. Present Value of Bonds n n n Present Value (PV) of a bond = PV of face + PV of interest payments All PVs are discounted at the effective interest rate, not at the stated interest rate. Book value (BV) of a bond = Face amount ($) - Unamortized discount (or + unamortized premium). Long-Term Liabilities 63

Book Value vs. Present Value of Bonds § § The effective interest method assuming a constant effective interest rate (i. e. , 6% in example 2) over the life of the bond When the effective interest method is used to amortize the discount , the BV of bonds equals the PV of bonds calculated using the historical effective interest rate (i. e. , 6% as in example 2). Long-Term Liabilities 64

Historical Effective Interest vs. Current Effective Interest § § However, the effective interest rate is usually changing from period to period during the life of a bond. The effective interest rate would change when the factors underlying this interest rate changed (i. e. , the market interest rate, the risk of the issuer, etc. ). Long-Term Liabilities 65

The Fair Value Option for Bonds – SFAS No. 159 § § § As a result, the book value of bonds, very often, does not equal the present value of bonds using the current effective interest rate (referred to as the fair value). Fair value of bonds: the present value of bonds calculated using the current, not the historical, effective interest rate. SFAS 159 allows companies to have the option to report the fair value of the bond on the balance sheet. Long-Term Liabilities 66

The Fair Value Option (Contd. ) § § § This option is referred to as the fair value option for bonds payable. The difference between the fair value of bonds and the book value (i. e. , the present value under the historical rate) is calculated at the end of each period. This difference is reported as losses (i. e. , fair value > book value) or gains (i. e. , fair value < book value) in the income statement. Long-Term Liabilities 67

SFAS 159 § § The fair value option for financial assets and liabilities is to provide an option of reporting financial assets (i. e. , investments in securities) and financial liabilities (i. e. , bonds payable) at fair value. The fair value option for financial liabilities is an optional reporting method. Long-Term Liabilities 68

SFAS 159 (contd. ) § § This reporting method can only be adopted at the issuance (origination) of a bond (loan). Once the fair value option is chosen, no change to other reporting method is allowed (i. e. , fair value option is an irrevocable decision). Long-Term Liabilities 69

SFAS 159 (contd. ) § § Companies can choose the fair value option for one, a few or all of their financial liabilities. Pension and lease liabilities are excluded from the fair value option. Long-Term Liabilities 70

Fair Value Measurement (SFAS 157) 1. Quoted market prices in active markets for identical assets or liabilities (i. e. , the market price of investments in equity securities), or 2. Quoted prices for similar assets or liabilities in markets (i. e. , quoted market prices for similar buildings), or Long-Term Liabilities 71

Fair Value Measurement (contd. ) 3. Applying the assumptions which market participants would also use in pricing the assets or liabilities (i. e. , applying a current effective interest to derive the present value of a bond). Note that when using this method to estimate the fair value, the impact of the fair value option on earnings should be disclosed. Source: supplement of Fair Value Option of Spiceland, etc. textbook Long-Term Liabilities 72

The Fair Value Option – An Example • Using Example 2 on p 48 (i. e. , issued a 5 -year term bond on 1/1/x 2 with $100, 000 face value, 5% stated interest , 6% effective interest and int. are paid on 6/30 and 12/31) , the present value equals $92, 641 on 1/1/x 2 using 6% as the discount rate. The book value under the effective interest method (to amortize the discount) equals $93, 199 on 6/30/x 2 (see p 58). Note: $93, 199=92, 641 + 558 amor. Discount. $93, 199 is also the present value of the bond on 6/30 under 6% discount rate. Long-Term Liabilities 73

The Fair Value Option – An Example (Contd. ) Assumed that the effective interest rate on 6/30 reduced to 5. 5% due to the decline in the primary interest rate, the present value of the bond on 6/30 using 5. 5% discount rate is (i. e. , the fair value of bonds on 6/30/x 2: PV of Principal = $100, 000 x 0. 6176=61, 760 PV of int. = $5, 000 x 6. 9522 =34, 761 Sum $96, 521 Note: PV is calculated using 5. 5% discount rate (not 6%) and 9 periods (not 10 periods). q Long-Term Liabilities 74

The Fair Value Option – An Example (Contd. ) The difference between the present value and the book value of the bond on 6/30 = $96, 521 - $93, 199 = $3, 322 Journal Entry to Apply the Fair Value reporting for the bond: 6/30 Unrealized holding loss 3, 322 Fair Value Adjustment 3, 322 q Long-Term Liabilities 75

The Fair Value Option – An Example (Contd. ) The reporting value of the bond under the fair value reporting option on 6/30/x 2 = The face $ of bonds = $100, 000 The unamort. Discount = ( 6, 801) the book value prior to fair value adjustment $ 93, 199 Fair value adjustment 3, 322 The book value after the fair value adjustment $ 96, 521 q Long-Term Liabilities 76

The Fair Value Option – An Example (Contd. ) q The reported value (referred to as the carrying value) of the bond after the fair value adjustment , $96, 521, is also the fair value of the bond using the current effective interest rate, 5. 5% (see p 76). Long-Term Liabilities 77

Accounting for Bonds Payable Bonds Are Issued at A Premium Information of example 3 is summarized with some additional information: n Stated Interest Rate (annual) = 10% n Effective Interest Rate (annual) = 8% n Date of Issuance = 1/1/x 2 (sold on 1/1/x 2) n Date of Maturity = 1/1/x 7 n Interest Payment Date = 6/30 and 12/31 n Face Value = $100, 000 n P. V. of the Bond = $108, 115 (as computed earlier) Long-Term Liabilities 78

Accounting for Bonds Payable. Bonds Are Issued at A Premium n n n Premium = $108, 114. 5 - 100, 000 = $8, 114. 5 The premium would decrease the interest expense and should be amortized over the life (5 years, 10 periods) of the bond. J. E. (Amortization Method= Straight-Line) $8, 114. 5 / 10 = $8114. 5 => $811. 45 would be amortized for every period. The interest expense would be decreased by $816 every period. 1/1/x 2 Cash 108, 114. 5 B/P 100, 000 Premium on Bonds Payable 8, 114. 5 Long-Term Liabilities 79

Accounting for Bonds Payable Bonds Are Issued at A Premium 6/30/x 2 Premium on Bonds Payable Interest Expense Cash 12/31/x 2 Premium on Bonds Payable Interest Expense Cash : : 6/30/x 6 Premium on Bonds Payable Interest Expense Cash Long-Term Liabilities 811. 45 4, 188. 55 5, 000 80

Accounting for Bonds Payable Bonds Are Issued at A Premium 12/31/x 6 Premium on Bonds Payable Interest Expense Cash 1/1/x 7 B/P Cash Premium on Bonds 6/30/x 2 811. 45 8114. 5 ---1/1/x 2 12/31/x 2 811. 45 4, 188. 55 5, 000 100, 000 Interest Expense for 10 periods = $4188. 55 x 10 = 41, 885. 5 = 50, 000 - 8, 114. 5 . 6/30/x 6 811. 45 Total Interest (cash) payment 12/31/x 6 811. 45 Premium on Discount 0 Long-Term Liabilities 81

Effective Interest Amortization Table-bond are issued at a premium Interest Expense = Cash payment - Amortized premium = 50, 000 - 8114. 5 = 41, 885. 5 * Rounding Error of $ 7 (968 -961 = 7) Long-Term Liabilities 82

Accounting for Bonds Payable Bonds Are Issued at A Premium (Effective Interest Method) J. E 1/1/x 2 Cash 108, 114. 5 B/P 100, 000 Premium on Bonds Payable 8114. 5 6/30/x 2 Interest Expense 4, 325 (Period 1) Premium on Bonds Payable 675 Cash 5, 000 12/31/x 2 Interest Expense 4, 298 (period 2) Premium on Bonds Payable 702 : Cash 5, 000 : 6/30/x 3 Period 3 Long-Term Liabilities 83

Accounting for Bonds Payable (Contd. ) (period 9) 6/30/x 6 Interest Expense Premium on B/P Cash 12/31/x 6 Interest Expense Premium on B/P Cash 1/1/x 7 B/P Cash (Retirement of Bonds at Maturity) Long-Term Liabilities 4, 076 924 5, 000 4, 032 968 5, 000 100, 000 84

Accounting for Bonds Payable (Contd. ) Premium on Bonds 6/30/x 2… 675 12/31/x 2 … 702 730 8114. 5 … 1/1/x 2 Interest Expense over 10 periods => Period $ 760 1 4, 325 790 2 4, 298 822 4, 270 855 889 924 10 968 0 41, 885. 50 Long-Term Liabilities 85

Bond Retirements Before Maturity n Use example 2 (see p 48), assume that bonds are retired at the end of period 3 for $98, 000 Discount on Bonds 7, 359 558…. . Period 1 592…. . Period 2 627…. . Period 3 5, 582 Unamortized at the end of period 3 BV of the Bond = 100, 000 - 5, 582 = 94, 418 Long-Term Liabilities 86

Bond Retirements Before Maturity (contd. ) B/P 100, 000 Loss on Retirement of Bonds 3, 582 Discount on Bonds Payable Cash 5, 582 98, 000 Long-Term Liabilities 87

Bond Retirements Before Maturity (contd. ) n Use example 2, assume that bonds are retired on 10/1/x 3 (half way through the 4 th period) at 97 plus accrued interest of $2, 500. Discount on B/P 7, 359 558 592 Amortized Dis. For period 4 627 (6 month) 3 months (665/2) bal. 5, 249. 5 Long-Term Liabilities 88

Bond Retirements Before Maturity (contd. ) 9/30/x 3 Interest Expense 2, 832. 5* Interest Payable 2, 500 Discount on B/P 332. 5 * Interest of period 4 (see p. 55 Amort. Table) $5, 665/2 10/1/x 3 B/P Interest Payable loss Cash Dis on B/P 100, 000 2, 500 2, 249. 5 99, 500 5, 249. 5 Long-Term Liabilities 89

Other Types of Debt Extinguishment: (skip p 90 -92) n n Defeasance of Debt: the debtor is legally released from being the primary debtor of the debt either by law or by the creditor (i. e. , the affiliate agrees to become the primary debtor for the debt). Accounting treatment: the liability is removed from the B/S. Long-Term Liabilities 90

Other Types of Debt Extinguishment (contd. ): n n In-substance defeasance: the debtor places cash or other assets in an irrevocable trust to be used for satisfying a specific debt. If the trust satisfies the following conditions, the FASB allows the company to remove the liability from its B/S: Long-Term Liabilities 91

Other Types of Debt Extinguishment: (Contd. ) 1. Trust is restricted to monetary assets that are risk free to the amount, the timing and collection of interests and principal. 2. The monetary assets must provide cash flows that are similar to the timing and the amount of the scheduled interests and principal payments on the debt being extinguished. Long-Term Liabilities 92

Accounting for Bonds Sold Between Interest Payment Dates: n Policy of interest payment for bonds: u. Interest are always paid in full regardless how long the bonds being held by the bondholder. u. Thus, the bond issuing company collects the accrued interests in addition to the issuing price when bonds are sold between interest payment dates. Long-Term Liabilities 93

Accounting for Bonds sold Between Interest Payment Dates at Par: n Example: On 2/1/x 2, Page company issued a 5 -year term bond with a face amount of $100, 000 and a stated interest rate of 10%. The bonds were sold on 5/1/x 2 at par and interests were paid semiannually on 2/1 and 8/1. Long-Term Liabilities 94

Accounting for Bonds Sold Between Interest Payment Dates at Par: n J. E. 5/1/x 2 (bond sold at par on 5/1/x 2) Cash Bonds Payable Interest Payable* 102, 500 100, 000 2, 500 * Accrued interest of 3 months (From 2/1 ~ 5/1) 8/1/x 2 Interest Payable* Interest Expense Cash 2, 500 * 100, 000 x 10% x 6/12 = 5, 000 (6 month interest) Interest Expense from 5/1/x 2 - 8/1/x 2 => 5, 000 -2, 500 = 2, 500 Long-Term Liabilities 5, 000 95

Debt Sold Between Interest Payment Dates at A Discount n n Green Company issued a two-year, 8% term bonds with a maturity value of $200, 000. The bonds are dated 1/1/x 2 and pay $8, 000 interest semiannually on 7/1 and 12/31. They are sold on 3/1/x 2 for $196, 123, which includes $2, 667 accrued interest from 1/1/x 2 to 3/1/x 2 to yield 5% interest semiannually. Long-Term Liabilities 96

Debt Sold Between Interest Payment Dates at A Discount or A Premium (Contd. ) Present value at 1/1/x 2 based on semiannual yield of 5% => P. V. of the principle 200, 000 x. 8227 = 164, 540 P. V. of Interest 8, 000 x 3. 5460 = 28, 368 P. V. on 1/1/x 2 $192, 908 Long-Term Liabilities 97

Debt Sold Between Interest Payment Dates At A Discount or A Premium (Contd. ) n The P. V. of the bonds on 3/1/x 2 => (PV 0 + Dis. Amortized for 2 months) => Dis. Amortized for 1/1/x 2 to 6/30/x 2 = 192, 908 x 0. 05 – 8, 000 = $1, 645. PV on 3/1/x 2 = $192, 908 + 1, 645 x 2/6 = 192, 908 + 548 = 193, 456 n Accrued interest from 1/1/x 2 to 3/1/x 2: = 200, 000 x 4% x 2/6=2, 667 Long-Term Liabilities 98

Debt Sold Between Interest Payment Dates At A Discount or A Premium (Contd. ) n Therefore, the selling price on 3/1/x 2 => 193, 456 + 2, 667 = $196, 123 (including the 2 -month accrued interest) * See the schedule on p 101 Long-Term Liabilities 99

Debt Sold Between Interest Payment Dates At A Discount or A Premium (Contd. ) n J. E. on 3/1/x 2 Cash 196, 123 Dis. On B/P 6, 544** B/P 200, 000 Interest Payable 2, 667 ** (200, 000 - 193, 456) or (200, 000 - 192, 908) - 548 Long-Term Liabilities 100

Debt Sold Between Interest Payment Dates At A Discount or A Premium (Contd. ) n Schedule of Interest & B. V * 192, 908 x 0. 05 = 9, 645 in which $3, 215 (9, 645 x 2/6) was for the period of 1/1/x 2 - 3/1/x 2 ** 9, 645 - 8, 000 =1, 645 in which $548 was for period of 1/1/x 2 - 3/1/x 2 Long-Term Liabilities 101

Debt Sold Between Interest Payment Dates At A Discount or A Premium (Contd. ) 7/1/x 2 Interest Expense Interest Payable Discount on B/P Cash 6, 4301 2, 6672 1, 097 8, 000 1. 9, 645 x 4/6= 6, 430 2. 1, 645 x 4/6 = 1, 097 12/31/x 2 Interest Expense Cash Discount on B/P Long-Term Liabilities 9, 728 8, 000 1, 728 102

Debt Sold Between Interest Payment Dates At A Discount or A Premium (Contd. ) 7/1/x 3 Interest Expense 9, 814 Cash Discount on B/P 8, 000 1, 814 12/31/x 3 Interest Expense 9, 905 Cash Discount on B/P 8, 000 1, 905 Discount on B/P 6, 544 1, 097 1, 728 1, 814 1, 905 0 Long-Term Liabilities 103

Accruing Bond Interest Assumed that Page Company issued a 5 year term bond with a face amount of $100, 000 and a stated interest of 10% on 10/1/x 2. The bonds were sold on 10/1/x 2 and interest were paid semiannually (on 10/1 and 4/1). The effective interest rate is 12%. Therefore, the present value of the bonds is $92, 640. 5. J. E 10/1/x 2 Cash 92, 640. 50 Discount 7, 359. 50 B/P 100, 000 n Long-Term Liabilities 104

Accruing Bond Interest (contd. ) 12/31/x 2 (adjusting entry for accrued interest expense) (Straight -line method) Interest Expense 2, 858 Interest Payable 2, 500 Discount on B/P* 368 7, 359. 50 / 5 x 3/12 = 368 (straight-line method) 12/31/x 2 (Effective interest method) Interest Expense* 2, 779 Interest Payable Discount on B/P * Effective Interest of 3 months: 92, 640. 50 x (12% x 1/2)Long-Term x 3/6 Liabilities = 2, 779 2, 500 279 105

Accruing Bond Interest (contd. ) Effective Interest Method: 4/1/x 3 Interest Expense 2, 779 Interest Payable 2, 500 Cash Discount on B/P 5, 000 279 10/1/x 3 Interest Expense 5, 591. 91* Cash 5, 000 Discount on B/P 591. 91 *(92, 640. 5+279) * 0. 06 = 5, 591. 91 Long-Term Liabilities 106

Bonds Issued with Detachable Stock Warrants (Stock Rights) n n Stock warrants represent rights that enable the security holder to acquire a specific number of common stock at a given price within a certain time period. Stock warrants are attached to bonds to increase their marketability Long-Term Liabilities 107

Bonds Issued with Detachable Stock Warrants (Stock Rights) (contd. ) n n These detachable warrants can be sold separately from the bonds in the open market within a short time of issue. APB Opinion 14 requires that a portion of the proceeds from bonds issued with detachable warrants be allocated to the stock warrants and accounted for as additional paid-in capital. Long-Term Liabilities 108

Bonds Issued with Detachable Stock Warrants (Stock Rights) (contd. ) n n The allocation is based on the relative market values of the bonds and warrants if the market values of bonds and warrants are both available. If only the market value (MV) of warrants is available, the MV of the warrants will be the amount allocated as the value of warrants. Long-Term Liabilities 109

Example n n n Paul Company sold $800, 000 of 12% bonds at 101. Each $1, 000 bond carried 10 warrants, and each warrant allowed the holder to acquire one share of $5 par common stock for $25 per share. After issuance, the bonds were quoted at 99 ex rights (without the right attached) and the warrants were quoted at $3 each. Long-Term Liabilities 110

Example (contd. ) n n Value Assigned to Bonds $990 800 = -------------------- $808, 000 $990 800 + ($3 800 10) = $784, 235. 29 Value Assigned to Warrants (right) $3 800 10 = -------------------- $808, 000 $990 800 + ($3 800 10) = $23, 764. 71 Long-Term Liabilities 111

Example (contd. ) * Bonds with the same risk can only be issued at 99 (rather than 101) without warrants J. E Cash 808, 000 Discount on B/P 15, 764. 71 B/P 800, 000 Comm. Stock Warrants 23, 764. 71 * $800, 000 -784, 235. 29 = 15, 764. 71 Long-Term Liabilities 112

Example (contd. ) $23, 764. 71 Value of One Warrant =--------- = $2. 971 10 800 If 500 of the warrants were exercised at the $25 per share exercise price, the entry is: Cash Common Stock Warrants Common Stock Additional Paid-in Capital on C. S 1. $25 x 500 3. 5 x 500 12, 500 1 1, 485. 50 2 2, 500 3 11, 485. 50 4 2. 2. 971 x 500 4. (12, 500 + 1485. 50) - 2, 500 Long-Term Liabilities 113

Example (contd. ) If the remaining warrants expire, the following entry would be made: Common Stock Warrants 22, 279. 21 1 Additional Paid-in Capital From Expired Warrants 22, 279. 21 1. 23, 764. 71 -1, 485. 50 Long-Term Liabilities 114

Convertible Bonds n n Bonds that may be converted into common stock at a specified price at the option of the holder. At issuance, the conversion price is usually greater than the market value of common stock. Long-Term Liabilities 115

Convertible Bonds (Contd. ) n n Convertible bonds are often issued with call option for the issuer. The issuer can force conversion by exercising its call option when share price has risen sufficiently in the future. Long-Term Liabilities 116

Convertible Bonds (contd. ) Reasons of issuing convertible bonds: 1. As an indirect way to issue stock when facing resistance from current stockholders to issue additional stock; 2. To issue bonds at a higher price (thus, lower effective interest rate); n Long-Term Liabilities 117

Convertible Bonds (contd. ) 3. Avoid the downward price pressure on its stock; 4. Avoid the direct sale of its stock when the company believes its stock currently is undervalued. Long-Term Liabilities 118

Accounting Treatment for Convertible Bonds n APB Opinion 14 requires that the issuance of convertible debt is recorded in the same manner as the issuance of nonconvertible debts without allocating a value (from the proceeds received) to the conversion feature. (Reason? ) Long-Term Liabilities 119

Recording for the Conversion Two acceptable methods: A. Book Value Method: the stockholders’ equity is recorded at the book value of the convertible bonds on the date of conversion. u No gain or loss is recorded upon conversion. u If the par value of the common stock is greater than the book value of the bonds, the difference is recorded as a reduction of retained earnings. Long-Term Liabilities 120

Recording for the Conversion (contd. ) B. Market Value Method: The stockholders’ equity is recorded at the market value of the shares issued on the date of conversion, and a gain or loss is recorded (treated as an ordinary income or loss). Long-Term Liabilities 121

Recording for the Conversion (contd. ) B. (continued) u. The gain or loss is the difference between the market value of the converted common stock and the book value of the bonds. If the conversion occurs between interest dates, the interest expense needs to be recorded and amortization of discount or premium also needs to be recognized to update the book value of the bonds. Long-Term Liabilities u 122

Example n Shannon Company has outstanding convertible bonds with a face value of $10, 000, interest has been paid on these bonds, and the bonds have a book value of $10, 500. Each $1, 000 bond is convertible into 40 shares of common stock (par value $20 per share). Long-Term Liabilities 123

Example (contd. ) n If all the bonds were converted into common stock when the market value of Shannon’s common stock is $26. 5 per share, the following alternative entries may be made: Long-Term Liabilities 124

Example (contd. ) A. Book Value Method: (BV of the bonds= $10, 500) (more commonly used by companies) Bonds payable 10, 000 Premium on Bonds Payable 500 Common Stock 1 8, 000 Paid-in Capital from Bond Conversion 2 2, 500 1. $20 x 40 x 10 2. 10, 500 - 8, 000 Long-Term Liabilities 125

Example (contd. ) B. Market Value Method : (MV of converted Stock = 26. 5 x (40 x 10) = 10, 600) Bonds payable 10, 000 Premium on B/P 500 Loss on Conversion 100 Common Stock 8, 000 Paid-in Capital from Bond Conversion 2, 600 1 1. 10, 600 - 8, 000 Long-Term Liabilities 126

Induced Conversions n n A Company may sweeten the conversion feature to induce the conversion of bonds to common stock in order to reduce interest costs. The additional cost is recognized as an expense. Long-Term Liabilities 127

Example n Harmon Company had issued convertible bonds at par. The conversion terms allowed each $1, 000 bond to be converted into 40 shares of common stock (par value $21 per share). Harmon induces the conversion terms to 50 shares if conversion is made in 60 days. Long-Term Liabilities 128

Example (contd. ) All bonds were converted within the time limit when the market price of the common stock is $30 per share. At the time of conversion, the book value of the bonds is $10, 000. Long-Term Liabilities 129

Example (contd. ) Using the book value method, the following entry will be recorded: Bonds Payable 10, 000 Bond Conversion Expense 3, 000 Common Stock ($ 21 x 50 x 10) 10, 500 Paid-in Capital in Excess * of Par Value 2, 500 *13, 000 - 10, 500 Long-Term Liabilities 130

Example (contd. ) If the market value method is used, the following entry will be recorded: B/P 10, 000 Bond Conversion Expense 3, 000 Loss on Conversion 2, 000 Common Stock ($21 x 50 x 10) 10, 500 Paid-in capital in Excess of Par 4, 500 Long-Term Liabilities 131

Long-Term Notes Payable n n APB Opinion No. 21 requires the longterm notes payable to be recorded at their present values. When notes are exchanged for cash, the cash received is considered the present value of the note. Long-Term Liabilities 132

Long-Term Notes Payable (contd. ) n n The effective interest rate (or the implicit rate) is the rate that equates the future net cash flows to the present value. The effective interest can be derived when the present value and future net cash flows are known. Long-Term Liabilities 133

Long-Term Notes Payable (contd. ) n In cases when the present value is unknown, the incremental interest rate of the borrower would be used as the effective rate to calculate the present value of the note. Long-Term Liabilities 134

Long-Term Notes Payable (contd. ) A. Notes payable issued for cash: u. When a long-term note is exchanged for cash, the note is assumed to have a present value equals the cash proceeds. u. The difference between the cash proceeds and the face value of the note is recorded as a discount (or premium) u. The discount (or premium) is amortized over the life of the note using the effective interest method. Long-Term Liabilities 135

Example n Johnson Company issued a 3 -year, noninterest-bearing note with a face value of $8, 000 and received $5, 694. 24 in exchange. The journal entry to record the issuance is: Cash Discount on Notes Payable Note Payable 5, 694. 24 2, 305. 76 8, 000 Long-Term Liabilities 136

Example (contd. ) n The discount account is a contra account to notes payable. The effective interest rate that equates the P. V. of 5, 694. 24 to $8, 000 at the end of 3 years is 12%. 5, 694. 24 = 8, 000 x 0. 71178 3 -period, 12% Long-Term Liabilities 137

Example (contd. ) The Interest Expense Per Year is Computed as: Long-Term Liabilities 138

Example (contd. ) Recognition of Interest Expense of Year 1: Interest Expense 683. 31 Discount on N/P 683. 31 Cash (non-interest bearing note) Long-Term Liabilities 0 139

Notes Payable Exchanged for Cash AND Rights or Privileges (skip p 139 -144) n A company might sign a contract with a customer in which the company borrows cash from the customer on a non-interest-bearing basis, with the understanding that the customer has the right to purchase certain goods from the company at less than prevailing market price over the period of the contract. Long-Term Liabilities 140

Example n n n Verna Company borrows $100, 000 by issuing a 3 -year, non-interest-bearing note to a customer. Verna agrees to sell inventory to the customer at reduced prices over a 5 -year period. Verna’s incremental borrowing rate is 12% so that the P. V. of $100, 000 to be repaid at the end of 3 years is $71, 178. . Long-Term Liabilities 141

Example (contd. ) n The customer agrees to purchase an equal amount of inventory each year over the 5 -year period so that a straight line method of revenue recognition is appropriate. Long-Term Liabilities 142

Example (contd. ) The following entries are recorded during the first two years: At the issuance of the Note Cash 100, 000 Discount on N/P 28, 822 N/P 100, 000 Unearned revenue 28, 822 Long-Term Liabilities 143

Example (contd. ) End of first Year Interest Exp. (71, 178 x 12%) 8, 541. 36 Discount on N/P 8, 541. 36 Unearned Revenue (28, 822/5) 5, 764. 40 Sales Revenue 5, 764. 40 End of Second Year Interest Exp. ((76, 178 + 8, 541. 36) x 12%) Discount on N/P Unearned Revenue Sales Revenue 9, 566. 32 5, 764. 40 Long-Term Liabilities 9, 564. 40 5, 764. 40 144

Notes Payable Exchanged for Cash AND Rights or Privileges (contd. ) Therefore, the accounting treatment is: 1. The note is recorded at the P. V. of the note at the time of issuance. 2. The difference between the cash proceeds (i. e. , $100, 000) and the P. V. of the note is recorded as unearned revenue ($100, 000 71, 178), and revenue is recognized over the life of the contract using an appropriated revenue recognition method. 3. The discount of the note is amortized over the life of the note using the effective interest method. Long-Term Liabilities 145

Notes Exchanged for Property, Goods, or Services n n APB 21 requires the note be recorded at the fair market value of the property, goods, or services or the fair value of the note, whichever is more reliable. The effective interest rate is calculated and used to calculate subsequent interest expense using the effective interest method. Long-Term Liabilities 146

Notes Payable Exchanged for Property, Goods, or Services (contd. ) If neither of these values is n determinable, the incremental borrowing rate of the borrower would be used as the effective interest rate to calculate the present value of the note. Long-Term Liabilities 147

Example n n n On 1/1/x 5, Marden Company purchases an equipment by issuing a non-interestbearing 5 -year note with a face value of $10, 000. Neither the fair market value of the equipment nor that of the note is determinable. The incremental borrowing rate of Marden is 12%. Long-Term Liabilities 148

Example (contd. ) J. E. 1/1/x 5 Equipment Discount on N/P 5, 674. 27* 4, 325. 73 N/P 10, 000 * P. V. of the note using 12% as the effective interest rate => 10, 000 x 0. 567427 Long-Term Liabilities 149

Example (contd. ) 12/31/x 5 Int. Exp. (5674. 27 x 12%) 680. 91 Discount on N/P 680. 91 Depreciation Expense 567. 43 Accumulated Depreciation 567. 43 (Assuming a S-L depreciation method is used and a 10 -year life is assumed for the equipment) Long-Term Liabilities 150

Example (contd. ) 12/31/x 6 Int. Exp. (5, 674. 27 + 680. 91) x 12% 762, 62 Discount on N/P 762. 62 Depreciation Expense 567. 43 Accumulated Depreciation Long-Term Liabilities 567. 43 151

Example (contd. ) n Using the previous example, except that the fair market value the equipment was determined at $6, 209. 21. The interest rate that equates the future cash flows to the present value of $6, 209. 21 is 10%. Long-Term Liabilities 152

Example (contd. ) The following entries would be recorded for 20 x 5 and 20 x 6: 1/1/x 5 Equipment 6, 209. 21 Discount on N/P 3, 790. 89 N/P 10, 000 12/31/x 5 Int. Exp. (6, 209. 21 x 10%) 621 Discount on N/P 621 12/31/x 6 Int. Exp. (6, 209. 21 + 621) x 10% 683 Discount on N/P 683 n Long-Term Liabilities 153

Installment Notes n n Notes could be paid by installments rather than by a single amount at maturity. Using the above example on page 151, assuming an installment payment at the end of each year for the following 5 years, ( starting 12/31/x 5), the annual installment payment for the note (loan) equals: $6, 209. 21/ 3. 79079=$1, 638 Long-Term Liabilities 154

Installment Notes: (Contd. ) n Journal Entries: 1/1/x 5 Equipment 6, 209. 21 Note Payable 6, 209. 21 12/31/x 5 Interest Exp. * 621 N/P 1, 017 Cash 1, 638 *6, 209. 21 x 10% = 621 12/31/x 6 Interest Exp. * 519 N/P 1, 119 Cash 1, 638 *(6, 209. 21 - 1, 017) x 10% = 519. 2 Long-Term Liabilities 155

Installment Notes: (Contd. ) n Journal Entries: 12/31/x 7 Interest Exp. * 407 N/P 1, 231 Cash 1, 638 *(6, 209 -1, 017 -1, 119) x 10% = 407 12/31/x 8 Interest Exp. * 284 N/P 1, 354 Cash 1, 638 *(6, 209 -1, 017 -1, 119 -1, 231) x 10% = 284 12/31/x 9 Interest Exp. * 149 N/P 1, 489 Cash 1, 638 *(6, 209 -1, 017 -1, 119 -1, 231 -Long-Term 1, 354) x 10% = 149 Liabilities 156

Installment Notes: (Contd. ) N/P 1017 6209 1119 1231 1354 1489 0* rounding error = $1 Long-Term Liabilities 157

Installment Notes: (Contd. ) n n An installment note typically is recorded at its carrying amount (i. e. , the face amount - the unamortized discount). This is because the outstanding balance of an installment does not become its face amount as in the case for notes with a single payment at maturity. Long-Term Liabilities 158

Long-term Notes Receivable (skip p 158 -170) n n If a long-term note received from selling property, goods, providing service, the note is recorded at the fair market value of the property goods, or services or the fair market value of the note (the present value if known), whichever is more reliable. An effective interest rate will then be derived and used to amortized the discounts or premiums. Long-Term Liabilities 159

Long-term Notes Receivable (contd. ) n n If neither of these values is reliable, the note is recorded at its present value by using the borrower’s incremental interest rate (as the effective interest rate). The effective interest method is used to record subsequent interest revenue. Long-Term Liabilities 160

Example n Joyce Company accepted a $10, 000, noninterest-bearing, 5 year note on 1/1/x 5 in exchange for an equipment sold to Marden Company. Since a reliable fair market value of the equipment or the note was not available, Marden’s (the borrower) 12% incremental borrowing rate was used to determine the P. V. of $5, 674. 27 for the note. The cost of the equipment is $8, 000 and the book value is $5, 000 on the date of sale. Long-Term Liabilities 161

Example (contd. ) The following entries will be recorded for Joyce: 1/1/x 5 Notes Receivable 10, 000 Accumulated Depreciation 3, 000 2 Discount on N/R 1 4, 325. 73 Equipment 8, 000 Gain on Sale of Equipment 3 674. 27 1. 100, 000 -5, 674. 27 2. 8, 000 - 5, 000 (B. V. ) 3. P. V. of the Note - B. V. of the Equipment = 5, 674. 27 - 5, 000 Long-Term Liabilities 162

Example (contd. ) 12/31/x 5 Discount on N/R 1 Interest Revenue 680. 91 1. 5, 674. 27 x 12% P. V. of Note on 1/1/95 12/31/x 6 Discount on N/R 1 Interest Revenue 762. 62 1. (5, 674. 27 + 680. 92) x 12% Long-Term Liabilities 163

Impairment of A Loan (FASB 114) n n A loan (note receivable) is impaired if it is probable that the creditor will be unable to collect all amounts due according to the (contractual) terms of the loan agreement. When a loan is found to be impaired, the creditor company (often a financial institution) computes the present value of the expected future cash flows of the impaired loan using the original effective interest rate on the loan. Long-Term Liabilities 164

Impairment of Loan (FASB 114) (contd. ) n The amount by which the present value is less than the recorded investment in the loan is recognized as Bad Debt Expense and Allowance for Doubtful Notes. Long-Term Liabilities 165

Example n Assuming Snook Company has a 6 -year note receivable of $100, 000 from the Ullman Company on 1/1/x 2 that is being carried at face value. The loan agreement specifies that interest of 8% is payable each 12/31 and the principal is to be paid on 12/31/x 7. The Ullman paid the interest due on 12/31/x 2, but informed the Snook Company that it probably would have to miss the next two year’s interest payments. Long-Term Liabilities 166

Example After that, it expected to resume the $8, 000 annual interest payments, but the principal payment would be made one year late with interest paid for the additional year. The present value P. V. of the impaired loan of Snook on 12/31/x 2 is: Long-Term Liabilities 167

Example (contd. ) n P. V. of Principal = $100, 000 x P. V. of a single sum for 6 years at 8% = $100, 000 x 0. 630170 = $63, 0170 n P. V. of Interest = $8, 000 x 3. 312127 x 0. 857329 = $22, 716. 93 annuity of 4 years at 8% years Long-Term Liabilities Defer for 2 168

Example (contd. ) n P. V. of the Impaired Loan = 63, 017 + 22, 716. 93 = $85, 733. 93 n The amount of impairment = $100, 000 - 85, 733. 93 = $14, 266. 07 Long-Term Liabilities 169

Recognition of the Impairment 12/31/x 2 Bad Debt Expense 14, 266. 07 Allowance for Doubtful Notes 14, 266. 07 At Dec. 31, x 3, Snook recognized interest revenue of $6, 858. 71: 12/31/x 3 Allowance for Doubtful Notes 6, 858. 71* Interest Revenue 6, 858. 71 * $85, 733. 93 x 8% = 6, 858. 71 the new carrying value of the impaired note Long-Term Liabilities 170

Recognition of the Impairment (contd. ) 12/31/x 2 Allowance for Doubtful Notes** Interest Revenue ** (85, 733. 93 + 6, 858. 71) x 8% 7, 407. 41 Long-Term Liabilities 7, 407. 41 171

Troubled Debt Restructuring n When the borrower is in severe financial difficulties, the creditor(s) may change the terms of debt agreement (i. e. , reduce the amount of principal or reduce the amount of interest payments or both. ) rather than force the borrower to liquidate. Long-Term Liabilities 172

Troubled Debt Restructuring (Contd. ) n n This new agreement is referred to as a trouble debt restructuring. A trouble debt restructuring can be one of the following: 1. The debt is settled at the time of restructuring ; or 2. The debt is continued but with modified terms. Long-Term Liabilities 173

(Contd. ) Troubled Debt Restructuring A. Debt is Settled: n The debtor’s gain = the carry amount of the debt - the value of the asset(s) transferred to settle the debt. Long-Term Liabilities 174

(Contd. ) Troubled Debt Restructuring A. Debt is Settled: n Example 1: A bank holding a $50 million note agrees to accept a land valued at $40 million from R. J. company, which is in severe financial difficulties, as a settlement of the $50 million debt. Long-Term Liabilities 175

(Contd. ) Troubled Debt Restructuring A. Debt is Settled: n Assumed that the carrying amount of the land is $32 million. The following journal entries are recorded for this troubled debt restructuring: ($ in million) 1)Land (40 million-32 million) 8 Gain on disposition of assets 8 2)Note Payable 50 Land(at fair value) 40 Gain on troubled debt restructuring 10 Long-Term Liabilities 176

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n In this case of troubled debt restructuring, the bank allows the debt to continue but modifies the terms of debt agreement, such as: 1) reduce or delay the interest payments; 2) reduce or delay the maturing amount; 3) a combination of these concessions. Long-Term Liabilities 177

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n Example 2: Assuming a 10% stated interest on the $50 million note is in question and interests($50 million x 10% = 5 million) are payable in December of the two remaining years. In addition, R. J. failed to pay $5 million of interest for the year just ended. Therefore, the carrying amount of the debt is $55 million. Long-Term Liabilities 178

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n The accounting treatment for this type of trouble debt restructuring depends on the total amount of future cash payments. n Case I : Total future cash payments < The carrying amount of the debt Long-Term Liabilities 179

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: Accounting Treatment: a)Recognize a gain (extraordinary) equals the difference between the carrying amount of the debt and the total future cash payments b)Reduce the carrying amount of the debt to the total future cash payments by: 1) reducing the accrued interests, and 2) reducing the debt. n Long-Term Liabilities 180

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n Accounting Treatment (contd. ): C) If entire accrued interests were eliminated, all subsequent cash payments are payments for the debt itself. Long-Term Liabilities 181

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n Continued with Example 2, assuming that the bank agrees to the following terms: a)Eliminate the accrued interest of last year; b)Reduce the remaining two interest payments from $ 5 million each to $3 million each; and c)Reduce the maturity value from $50 million to $40 million. Long-Term Liabilities 182

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n Extraordinary Gain: Carrying Amount $55 million Future Cash Payments* $46 million Gain $ 9 million * $3 million x 2+ 40 million = $46 million Long-Term Liabilities 183

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n J. E. ($ in million) Interest Payable 5 Note Payable** 4 Gain on debt restructuring 9 ** Balance of this debt = $50 -4 = $46 million= Total future cash payments on this debt Long-Term Liabilities 184

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n n J. E. At each of the two interest payment dates 12/X+1 ($ in million) Note Payable 3 Cash 3 12/X+2 Note Payable 3 Cash 3 At maturity: Note Payable 40 Cash 40 (revised principal amount) Long-Term Liabilities 185

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n n n Case II: Total cash payments exceed the carrying amount of the debt Continued with example 2, assuming that the bank agrees to delay the due date for all cash payments until maturity date and accept $57, 222, 000 at maturity date. Since $57, 222, 000 exceeds the carrying amount of the debt ($55 million), the new agreement still require an interest payment. Long-Term Liabilities 186

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: n A new effective interest rate needs to be calculated as follows: $55, 000 / $57, 221, 927=0. 96117 The present value table (6 A-2) indicates that the new effective interest rate is 2%. Long-Term Liabilities 187

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: J. E. 1)At the debt restructuring date: no entry is required. n 2)At the end of the first year following the restructuring: Int. Exp. (2%x$55 million) 1, 100, 000 Interest Payable 1, 100, 000 Long-Term Liabilities 188

(Contd. ) Troubled Debt Restructuring B. Debt is Continued but with Modified Terms: 3)At the end of the second year Interest Exp. * 1, 122, 000 Interest Payable 1, 122, 000 * 2% x ($55 million + 1, 100, 000) 4)At maturity Date: Note Payable Interest Payable Cash 50, 000 7, 222, 000 57, 222, 000 Long-Term Liabilities 189