Financial Accounting Chapter 4 Long Term Liabilities What

Financial Accounting Chapter 4: Long Term Liabilities

What is a Liability? A liability is defined as: • a present obligation of an entity • arising from past events • the settlement of which is expected to result in an outflow of resources that embody economic benefits.

What is a Non – Current Liability? IAS 1 defines non-current liabilities as liabilities other than current liabilities.

What is a Current Liability? IAS 1 states that a liability should be classified as a current liability if it satisfies any of the following criteria: • The entity expects to settle the liability in its normal operating cycle. • The liability is held primarily for the purpose of trading. • It is due to be settled within 12 months after the end of the reporting period. • The entity does not have the unconditional right to defer settlement of the liability for atleast 12 months after the end of the reporting period.

Typical Non-Current Liabilities 1. Bonds payable 2. Notes / Loans payable 3. Deferred tax liability 4. Pensions payable 5. Finance lease payable Not all bonds payable or bank loans payable are long-term in nature. Bond and loan repayments that are due within a year are classified as current liabilities and the rest are reported as long-term.

Bonds Payable Long-term finance is usually obtained by issuing bonds. Bonds are issued by governments, corporations and other entities. A bond is a debt instrument, generally issued to many investors, that requires future repayment of the original amount at a fixed date, as well as periodic interest payments during the intervening period. Bonds are transferrable so individual bondholders may sell their bonds to other investors at any time.

Bonds Payable - Characteristics 1. Par value / Face value / Nominal value 2. Coupon Rate / Nominal Rate / Interest Rate 3. Maturity 4. Credit Quality 5. Embedded Options

Bonds Payable - Characteristics Par value / Face value / Nominal value: The par value of a bond is the amount at which the issuing entity will redeem the bond certificate on the maturity date. The par value is also the amount upon which the entity calculates the interest that it owes to investors. Thus, if the stated interest rate on a bond is 10% and the bond par value is Rs. 1, 000, then the issuing entity must pay Rs. 100 every year until it redeems the bond.

Bonds Payable - Characteristics Coupon Rate / Nominal Rate / Interest Rate Coupon is the interest rate the issuer pays to the bondholder. It is usually expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is Rs. 10, 000, its annual interest would be Rs. 10, 000*10% = Rs. 1000. Suppose the market value of the bond changes to Rs. 20, 000. This would have no effect on the coupon rate which is still 10% of the par value (Rs. 10, 000) of the bond. However, the bondholders (the lenders) are now receiving Rs. 1, 000 on an investment worth Rs. 20, 000. This is a return of 5%. This is known as the yield on the bond.

Bonds Payable - Characteristics Coupon Rate / Nominal Rate / Interest Rates that remain as a fixed percentage of the par value are considered as Fixed-rate bond. Interest rate can also vary with a money market index, such as LIBOR. Such bonds are called floating-rate bonds.

Bonds Payable - Characteristics Maturity is the date on which the principal amount of a bond or other debt instrument becomes due and is reimbursed back to the investor and thereafter the interest payments stop.

Bonds Payable - Characteristics Credit Quality Credit quality informs investors of a bond or bond portfolio's credit worthiness or risk of default. A company or security’s credit quality may also be known as its “bond rating. " There are many rating agencies that rate the bonds according to the risk factor of the bonds. For example, International rating agencies are Moody’s, S&P. In Pakistan PACRA and VIS rate the bonds of companies of Pakistan.

Bonds Payable - Characteristics Credit Quality Bond risk increases due to the following reasons. • Excessive borrowing or debt • Operating losses • Small size of business • Large variations in income • Country & foreign exchange rate risk

Bonds Payable - Characteristics Embedded Options In the broadest terms, embedded options are components built into the structure of a financial security that provide the option of one of the parties to exercise some action under certain conditions. Each investor has a unique set of income needs, risk tolerances, tax rates, liquidity needs and time horizons — embedded options provide a variety of solutions to fit all participants.

Bonds Payable - Characteristics Embedded Options: Examples Call option An option that allows the issuer to buy back or redeem bonds at some time in the future before the maturity date. Bonds that have a call option are referred to as callable bonds. Put option Some bonds give the holder the right to force the issuer to repay the bond before the maturity date. These are referred to as retractable or putable bonds. Conversion option The bond holder has the option to convert that bond into stock of company. Such bonds are called convertible bonds.

Bonds Payable - Classification • Secured and Unsecured bonds • Fixed rate bonds, Floating rate bonds and Zero-coupon bonds • Registered bonds and Bearer (Coupon) bonds • Term, Serial, and Callable bonds • Perpetual bonds • Convertible bonds • High yield bonds or junk bonds

Bonds Payable – Valuation Investment community values a bond at the present value of its expected future cash flows, which consist of a) Interest and b) Principal.

Bonds Payable – Valuation Interest Rate Stated, coupon, or nominal rate Rate written in the terms of the bond indenture. Bond issuer sets this rate. Stated as a percentage of bond face value (par). Effective Interest Rate The effective interest rate is the true rate of interest earned by the bondholders. It could also be referred to as the market interest rate, the yield to maturity, the discount rate, the internal rate of return, the annual percentage rate (APR), and the targeted or required interest rate.

Bonds Payable – Valuation How do you calculate the amount of interest that is actually paid to the bondholder each period? (Stated rate x Face Value of the bond) How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds? (Effective rate x Carrying Value of the bond)

Bonds Payable – Valuation (At Par) Santos Company issues R$100, 000 in bonds dated January 1, 2015, due in five years with 9 percent interest payable annually on January 1. At the time of issue, the market rate for such bonds is 9 percent.

Bonds Payable – Valuation Assume Nominal Rate of 8% Market Interest Bonds Sold At 6% Premium 8% Par Value 10% Discount

Bonds Payable – Valuation Initial Recognition: Fair Value including transaction cost Subsequent Recognition: Amortized cost using Effective Interest Method The amortised cost of a financial liability is calculated as: • amount initially recognised as a liability (initial cost); plus • interest expense recognised (using the effective rate); less • interest actually paid (cash paid). Interest expense is measured using the effective rate. This is the rate that matches the amount borrowed with the discounted future cash flows paid.

Bonds Payable – Valuation (At Par) Santos Company issues R$100, 000 in bonds dated January 1, 2015, due in five years with 9 percent interest payable annually on January 1. At the time of issue, the market rate for such bonds is 9 percent.

Bonds Payable – Valuation (At Par) Journal entry on date of issue, Jan. 1, 2015. Cash 100, 000 Bonds payable 100, 000 Journal entry to record accrued interest at Dec. 31, 2015. Interest expense 9, 000 Interest payable 9, 000 Journal entry to record first payment on Jan. 1, 2016. Interest payable Cash 9, 000

Bonds Payable – Valuation (At Discount) Assuming now that Santos issues R$100, 000 in bonds, due in five years with 9 percent interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11 percent.

Bonds Payable – Valuation (At Discount) Journal entry on date of issue, Jan. 1, 2015. Cash 92, 608 Bonds payable 92, 608 Journal entry to record accrued interest at Dec. 31, 2015. Interest expense 10, 187 (92, 608 *11%) Interest payable 9, 000 (100, 000 * 9%) Bonds Payable 1, 187 (amortization of discount) Journal entry to record first payment on Jan. 1, 2016. Interest payable Cash 9, 000

Bonds Payable – Valuation Illustration: Evermaster Corporation issued € 100, 000 of 8% term bonds on January 1, 2015, due on January 1, 2020, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 10%. Calculate the bond proceeds. .

Bonds Payable – Valuation (At Discount)

Bonds Payable – Valuation (At Discount) Journal entry on date of issue, Jan. 1, 2015. Cash 92, 278 Bonds Payable 92, 278

Bonds Payable – Valuation (At Discount) Journal entry to record first payment and amortization of the discount on July 1, 2015. Interest expense 4, 614 Bonds payable Cash 4, 000 614

Bonds Payable – Valuation (At Discount) Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2015. Interest expense 4, 645 Interest payable 4, 000 Bonds payable 645

Bonds Payable – Valuation (At Premium) Illustration: Evermaster Corporation issued € 100, 000 of 8% term bonds on January 1, 2015, due on January 1, 2020, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 6%. Calculate the bond proceeds. .

Bonds Payable – Valuation (At Premium)

Bonds Payable – Valuation (At Premium) Journal entry on date of issue, Jan. 1, 2015. Cash 108, 530 Bonds payable 108, 530

Bonds Payable – Valuation (At Premium) Journal entry to record first payment and amortization of the premium on July 1, 2015. Interest expense 3, 256 Bonds payable 744 Cash 4, 000

Bonds Payable – Valuation (Accrued Interest) Accrued Interest What happens if Evermaster prepares financial statements at the end of February 2015? In this case, the company prorates the premium by the appropriate number of months to arrive at the proper interest expense, as follows.

Bonds Payable – Valuation Accrued Interest Evermaster records this accrual as follows: Interest expense 1, 085. 33 Bonds payable 248. 00 Interest payable 1, 333. 33

Notes Payable Accounting is Similar to Bonds • A note is valued at the present value of its future interest and principal cash flows. • Company amortizes any discount or premium over the life of the note.

Notes Payable – Valuation (Issued at Face Value) Coldwell, Inc. issued a € 100, 000, 4 -year, 10% note at face value to Flint Hills Bank on January 1, 2015, and received € 100, 000 cash. The note requires annual interest payments each December 31. Prepare Coldwell’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment. (a) Cash 100, 000 Notes payable (b) Interest expense 100, 000 10, 000 Cash 10, 000 (€ 100, 000 x 10% = € 10, 000)

Notes Payable – Valuation Zero-Interest-Bearing Notes Issuing company records the difference between the face value and the present value (cash received) as • a discount and • amortizes that amount to interest expense over the life of the note.

Notes Payable – Valuation (Issued at Discount) Illustration (zero-interest bearing note): Turtle Cove Company issued the three-year, $10, 000, zero-interest-bearing note to Jeremiah Company. The implicit rate that equated the total cash to be paid ($10, 000 at maturity) to the present value of the future cash flows ($7, 721. 80 cash proceeds at date of issuance) was 9 percent. Turtle Cove records issuance of the note as follows. Cash 7, 721. 80 Notes Payable 7, 721. 80

Notes Payable – Valuation (Issued at Discount)

Notes Payable – Valuation (Issued at Discount) Turtle Cove records interest expense for year 1 as follows: Interest Expense 694. 96 Notes Payable ($7, 721. 80 x 9%) 694. 96

Notes Payable – Valuation (Issued at Discount) Illustration (interest bearing note): Marie Co. issued for cash a € 10, 000, three-year note bearing interest at 10 percent to Morgan Corp. The market rate of interest for a note of similar risk is 12 percent. 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 exchanged at a discount.

Notes Payable – Valuation (Issued at Discount) Illustration (interest bearing note): Marie Co. issued for cash a € 10, 000, three-year note bearing interest at 10 percent to Morgan Corp. The market rate of interest for a note of similar risk is 12 percent. 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 exchanged at a discount. Marie Co. records the issuance of the note as follows: Cash 9, 520 Notes Payable 9, 520

Notes Payable – Valuation (Issued at Discount)

Notes Payable – Valuation (Issued at Discount) Marie Co. records the following entry at the end of year 1: Interest Expense 1, 142 Notes Payable Cash 1, 000 142

Non-Current Liabilities – Redemption Redeeming loan at maturity Payable XXX Cash XXX

Non-Current Liabilities – Redemption Special issues related to extinguishment of non – current liability a) Extinguishment with cash before maturity, b) Extinguishment by transferring assets or securities, and c) Extinguishment with modification of terms.

Non-Current Liabilities – Redemption Extinguishment with cash before maturity • Net carrying amount > Reacquisition price = Gain • Net carrying amount < Reacquisition price = Loss • At time of reacquisition, unamortized premium or discount must be amortized up to the reacquisition date.

Non-Current Liabilities – Redemption Illustration (Extinguishment with cash before maturity): Evermaster bonds issued at a discount on January 1, 2015. These bonds are due in five years. The bonds have a par value of € 100, 000, a coupon rate of 8% paid semiannually, and were sold to yield 10%.

Non-Current Liabilities – Redemption Illustration (Extinguishment with cash before maturity): Evermaster bonds issued at a discount on January 1, 2015. These bonds are due in five years. The bonds have a par value of € 100, 000, a coupon rate of 8% paid semiannually, and were sold to yield 10%. Two years after the issue date on January 1, 2017, Evermaster calls the entire issue at 101 and cancels it.

Non-Current Liabilities – Redemption Evermaster records the reacquisition and cancellation of the bonds as follows: Bonds Payable 94, 925 Loss on Extinguishment of Bonds Cash 6, 075 101, 000

Non-Current Liabilities – Redemption Extinguishment by Exchanging Assets or Securities • Creditor should account for the non-cash assets or equity interest received at their fair value. • Issuer (Debtor) recognizes a gain equal to the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain).

Non-Current Liabilities – Redemption Illustration (Extinguishment by Exchanging Assets): Hamburg Bank loaned € 20, 000 to Bonn Mortgage Company. Bonn, in turn, invested these monies in residential apartment buildings. However, because of low occupancy rates, it cannot meet its loan obligations. Hamburg Bank agrees to accept from Bonn Mortgage real estate with a fair value of € 16, 000 in full settlement of the € 20, 000 loan obligation. The real estate has a carrying value of € 21, 000 on the books of Bonn Mortgage. Bonn (debtor) records this transaction as follows. Note Payable (to Hamburg Bank) 20, 000 Loss on Disposal of Real Estate 5, 000 Real Estate 21, 000 Gain on Extinguishment of Debt 4, 000

Non-Current Liabilities – Redemption Illustration (Extinguishment by Exchanging Securities): Now assume that Hamburg Bank agrees to accept from Bonn Mortgage 320, 000 ordinary shares (€ 10 par) that have a fair value of € 16, 000, in full settlement of the € 20, 000 loan obligation. Bonn Mortgage (debtor) records this transaction as follows: Notes Payable (to Hamburg Bank) 20, 000 Share Capital—Ordinary 3, 200, 000 Share Premium—Ordinary 12, 800, 000 Gain on Extinguishment of Debt 4, 000

Non-Current Liabilities – Redemption Extinguishment by Modification of Terms Creditor may offer one or a combination of the following modifications: • Reduction of the stated interest rate. • Extension of the maturity date of the face amount of the debt. • Reduction or deferral of any accrued interest.

Non-Current Liabilities – Redemption Illustration (Extinguishment by Modification of Terms): On December 31, 2015, Morgan National Bank enters into a debt modification agreement with Resorts Development Company. The bank restructures a ¥ 10, 500, 000 loan receivable issued at par (interest paid to date) by: • Reducing the principal obligation from ¥ 10, 500, 000 to ¥ 9, 000; • Extending the maturity date from December 31, 2015, to December 31, 2019; and • Reducing the interest rate from the historical effective rate of 12 percent to 8 percent. Given Resorts Development’s financial distress, its market-based borrowing rate is 15 percent.

Non-Current Liabilities – Redemption IFRS requires the modification to be accounted for as an extinguishment of the old note and issuance of the new note, measured at fair value.

Non-Current Liabilities – Redemption The gain on the modification is ¥ 3, 298, 664, which is the difference between the prior carrying value (¥ 10, 500, 000) and the fair value of the restructured note. Given this information, Resorts Development makes the following entry to record the modification: Note Payable (old) 10, 500, 000 Gain on Extinguishment of Debt 3, 298, 664 Note Payable (new) 7, 201, 336

Non-Current Liabilities – Redemption Amortization schedule for the new note.

Non-Current Liabilities – Presentation Note disclosures generally indicate the • nature of the liabilities, • maturity dates, • interest rates, • call provisions, • conversion privileges, • restrictions imposed by the creditors, and • assets designated or pledged as security. Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.