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									CHAPTER 14 – LONG-TERM LIABILITIES [pages 688-739]


LEARNING OBJECTIVES

   1. Describe the formal procedures associated with issuing long-term debt.
   2. Identify various types of bond issues.
   3. Describe the accounting valuation for bonds at date of issuance.
   4. Apply the methods of bond discount and premium amortization.
   5. Describe the accounting for the extinguishment of debt.
   6. Explain the accounting for long-term notes payable.
   7. Explain the reporting of off-balance-sheet financing arrangements.
   8. Indicate how to present and analyze long-term debt.
  *9. Describe the accounting for a debt restructuring.
*Material covered in Appendix

I. Overview – Long-term Liabilities (Bonds and Notes Payable)

       A. What is long-term debt?
          1. probable future sacrifices of economic benefit

          2. payable in the future, normally beyond one year or operating cycle
             whichever is longer

          3. Examples: bonds payable, long-term notes payable, mortgage notes
             payable (topics of this chapter), pension liabilities and lease obligations.

       B. Why issue long-term debt (as opposed to equity)?
          1. May be only source of funds

          2. Lower cost

          3. Interest payments are tax deductible

          4. Creditors have no right to vote

          5. Takes advantage of financial leverage

II. Bonds Payable
    A. Contract (obligation) called a bond indenture
       1. to pay a sum of money

     2. at a designated maturity date plus periodic interest



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     3. at a specified rate on the face value.

     4. Repay principal at maturity

B. Types of Bonds: term, serial, secured and unsecured, convertible, commodity-
backed, deep discount, registered and coupon bonds.

C. Issuing of Bonds
     1. Can be through an underwriter (investment banker or brokerage firm)

     2. Private placement – usually to a large financial institution

D. Valuation of Bonds
     1. The denomination of a bond is called the face value, par value, principal,
         maturity value and face amount.

     2. Bonds are issued in multiples of $1,000 (i.e. the face of one bond is $1,000)

     3. Selling prices are quoted as a percentage of par value (102% = $1020)
        a. determined by the interaction of the stated interest rate and the market rate
        b. stated rate ( coupon, nominal, contract rate) is the interest rate appearing on
       the bond certificate
        c. market rate (effective or yield rate) is the rate actually earned.

E. Premium or Discount on Bonds Payable
     1. Discounts and premiums recorded at the time the bonds are sold.

     2. Discounts or premiums are amortized each time bond interest is paid.

     3. The time period for amortizing equals the period the bonds are outstanding

     4. Amortization of bond premiums decreases the recorded amount of bond interest
             expense,

     5. Amortization of bond discounts increases the recorded amount of bond interest
     expense

III. Accounting for Bonds

   A. Valuation

      1.   Price of a bond determined by the interaction between the bonds’s stated
               interest rate and its market rate.

      2. Price is equal to the sum of the present value of the principle and the present
             value of the periodic interest.

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          a. Stated rate = the market rate, the bond sells at par.
          b. Stated rate < the market rate, the bond sells at a discount.
          c. Stated rate > the market rate, the bond sell at a premium.

B. Issuance
     1. Face value always recorded in the bond payable account.

    2. If a bond sells at a discount, the difference between the sales price and the
   face value is debited to Discount on Bonds Payable. (contra-account to Bonds
   Payable).
                  Cash                                xxx
                  Discount on Bonds Payable           xxx
                        Bonds Payable                       xxx
    3. If a bond sells at a premium, the difference between the sales price and the
   face value is credited to Premium on Bonds Payable (an adjunct account to
   Bonds Payable).
                  Cash                                xxx
                        Premium on Bonds Payable            xxx
                        Bonds Payable                       xxx
    4. Bonds sold between interest dates

      a. Includes the interest accrued since the last interest payment.
      b. Accrued interest is credited to Bond Interest Expense.
                    Cash                     xxx
                        Interest Expense            xxx
                        Bonds Payable               xxx
               (Assuming bond is issued at par)
      c. a full interest payment is made to each investor on the next interest
          payment date
      d. accrued interest is recorded in:
          (1) Interest payable or
          (2) Interest expense

C. Amortization of bond discounts and premiums.
    1. Amortization period for premiums or discounts is the period of time that bonds
    are expected to be outstanding.

    2. Bond interest expense is increased by amortization of a discount and
    decreased by amortization of a premium.

    3. The effective interest method
       a. preferred procedure used to calculate periodic interest expense
       b. Carrying amount of the bonds at the start of the period is multiplied by the
              effective interest rate to determine the interest expense.



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   D. Effective Interest Method

       1. Carrying Value of Bonds = Face Value Plus Premium (or Less Discount).

       2. Interest Payable = Stated Interest Rate x Face Value of Bonds x Time.

       3. Interest Expense = Effective Interest Rate x Carrying Value of Bonds x Time.

       4. If a premium exists:
                      Interest Expense                                    XX
                      Premium on Bonds Payable                            XX
                                       Interest Payable                        XX
       5. If a discount exists:

                      Interest Expense                                    XX
                                         Discount on Bonds Payable             XX
                                         Interest Payable                      XX

      6. Straight-line method amortization may be used if interest expense is not
      materially different from the effective interest method.

      7. Issuance expenses are debited to a deferred charge account (Bond Issue
      Costs) and amortized over the life of the bond, usually using a straight-line
      method.

Example 1: Bradford Company issued 100, $1,000 bonds, with a stated interest rate of
6%, on January 1, 2010, to yield an effective interest rate (market rate) of 5%. The
bonds pay interest annually on December 31, and are due on December 31, 2015 (a 5-
year term for illustrative purposes only).

Required:
a. Compute the selling price of the bonds and any related premium or discount.

PV ordinary annuity of $6,000 per period for 5 yrs. @ 5%
      (always use market rate)                                       $25,976.88

PV $100,000 due in 5 periods at 5%                                     78,353.00
Selling Price (total PV)                                             $104,329.88

b. Record the Entry

      Cash            $104,330
        Bonds Payable                     $100,000
        Premium on Bonds Payable              4,330




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c. Balance Sheet Presentation

      Long-term Liabilities
      Bonds Payable                      $100,000
      Premium on Bonds Payable              4,330     104,330

IV. Amortization of Premium/Discount &
Interest Payments

      1. Effective interest method – constant rate each period (3-steps)

      Step 1:       Compute carrying value
                    Face value + Unamortized premium = Carrying value of bond
                              - Unamortized discount

      Step 2:       Compute interest expense
                    Carrying value of bond x effective rate x time = interest expense


      Step 3:       Compute amortization (and then compute new carrying value)
                    Interest expense – cash payment = amortization (plug figure)

Example 2: Bradford Company issued 100, $1,000 bonds, with a stated interest rate of
6%, on January 1, 2010, to yield an effective interest rate (market rate) of 5%. The
bonds pay interest annually on December 31, and are due on December 31, 2015 (a 5-
year term for illustrative purposes only).

Step 1:
PV ordinary annuity of $6,000 per period for 5 yrs. @ 5%
      (always use market rate)                                      $25,976.88

PV $100,000 due in 5 periods at 5%                                    78,353.00
Selling Price (total PV)                                            $104,329.88

Step 2:

$104,330 x .05 x 12/12 = $5,216

Step 3: 12/31/10
Interest Expense                $5,216
Premium on Bonds Payable           784 (plug)
        Cash                             6,000 (100,000 x .06 x12/12)




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V. Bonds Issued Between Interest Dates
   1. Increase the purchase price by an amount equal interest earned since the last
   interest payment date and credit interest expense for the amount of accrued interest.

  2. The bondholder receives the entire interest payment on the next payment date i.e.
  interest earned plus prepayment.

  3. Since Interest Expense has a credit balance upon interest payment, interest
  expense will reflect the corrected amount (Interest Expense – prepaid interest
  expense).

Example 3: Bradford Company issued 100, $1,000 bonds, with a stated interest rate of
6%, on April 1, 2010, to yield an effective interest rate (market rate) of 5%. The bonds
pay interest annually on December 31, and are due on December 31, 2015 (a 5-year
term for illustrative purposes only).

Accrued Interest 1/1/10-4/1/10 = $100,000 x .06 x 3/12 = $1,500

  4/1/10 Cash         $105,830
           Bonds Payable                        $100,000
           Premium on Bonds Payable                4,330
           Interest Expense                        1,500

12/31/10 Interest Expense         $5,216
         Premium on Bonds Payable    784
            Cash                                    6,000

VI. Retirement of Debt Prior to Maturity:

   1. Update carrying value of bonds (bring books up to date)

   2. Recognize gain or loss – difference between
      a. Carrying value of bonds
         (1) Face =+/- unamortized premium/discount
         (2) +unamortized issuance costs

      b. Cash paid to retire bonds (exclude accrued interest)
         (1) Price
         (2) +call premium
         (3) +reacquisition expenses

   3. Gains or losses on early extinguishment of debt are classified as “Other Gains
      and Losses” on the income statement




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Example 4: Assume that 40 of the Bradford bonds were retired on January 1, 2012 at
102 (a percentage of face value). The straight-line method is used to amortize the
discount.

      Required: Compute the extraordinary gain or loss on the early retirement of the
      debt.
            Face value of bonds                                 $100,000

            Plus: Unamortized premium                                  2,723

            Carrying value of bonds on January 1, 2012            $102,723

            x Percentage of bonds retired                         x      .40

            Carrying value of bonds retired                       $41,089

            Cost to retire bonds                                      40,800

            Extraordinary gain or loss                            $      289




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VII. Amortization and its Impact on the Balance Sheet and Income Statement

                                          Relationship between interest rates
                               Stated rate > effective rate   Stated rate < effective rate

Bond sells at a . . .                   premium                        discount


Carrying value of bond                 decreases                      increases
(over time)

Interest expense                       decreases                      increases
(over time)

Interest expense                          lower                         higher
(compared to cash payment)

Net income                               higher                          lower


Amount amortized                       increases                      increases
(over time)

VIII. Long-Term Notes Payable.

   A. Accounting for Long-term Notes Payable is similar to accounting for Bonds
      Payable.
         1. Value equals the present value of future interest and principal
         2. Amortize discounts or premiums over life of note

   B. The maturity date determines the difference between current notes payable and
      long-term notes payable

   C. Notes not issued at face value

       1.     Zero Interest-Bearing Notes Issued for Cash:

            a. Use the implicit interest rate:
               (1) the rate that equates the cash received (present value) with the
               amounts received in the future.
            b. Face amount of the note minus the present value of the note equals the
                  discount which is amortized to interest expense over the life of the
                  note.




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   2. Interest-Bearing Notes with an Effective Rate Different than the Stated
      Rate:
      a. If the stated interest rate is unreasonable, impute an interest rate to
      determine the present value of the note.
         b. Discounts or premiums are recognized and amortized to interest expense
                over the life of the note.
            Cash                           xxx
            Discount on Notes Payable xxx
                Notes Payable                  xxx

           Interest Expense            xxx
                Discount on Notes Payable xxx

   3. Special note payable situations.

    a.     Non-cash transactions:
           (1) Note exchanged for property, goods or services
           (2) Stated rate presumed fair unless:
               (a) No interest rate stated
               (b) Stated rate unreasonable
               (c) Face amount of note materially different from current cash price of
                   the consideration or market value of note payable.
         b. Imputed interest rate:
             (1)Use if stated rate is unfair or company cannot determine fair value
            (2) When interest is imputed, the effective interest method has to be used.
            (3) Journal entries are similar to entries for bonds payable issued at a
           discount.

    4.     Mortgage Notes Payable.

           a.   A promissory note secured by property.
           b.   Usually receive cash equal to face value of the note.
           c.   If lender assesses points, borrower receives less than face value of
                the note.
           (1). A point equals 1% of the notes’ face value.
           (2). Record as a note with a discount.
D. Off-balance sheet financing: an attempt to borrow so that the obligation is not
   recorded.
1. Examples:
   a. Non-consolidated subsidiary.
   b. Special Purpose Entity (SPE)



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   (1) An entity created by a company to perform a special project.
   (2) The SPE reports any liabilities on its books.
   c. Operating leases
       (1) Lease assets instead of buying them
       (2) and incurring debt to finance the purchase.

2. Rationale for off-balance sheet financing.
   a. Attempt to “enhance the quality” of the balance sheet.
   b. Conform to loan covenants.
   c. “Balance” understates assets.
   d. FASB’s response has been to require increased disclosure.

E. Reporting Long-Term Debt: Reported as one amount in the balance sheet and
   supported by additional comments in the notes.

1. If mature within one year, report as a current liability, unless retirement to be
   paid with other than current assets.
2. Disclosures generally indicate the nature of the liabilities, maturity dates, interest
    rates, call provisions, conversion privileges, restrictions imposed by borrower,
    and assets pledged as security.
3. Future payments for sinking fund requirements and maturity amounts of long-
    term debt during each of the next five years should be disclosed.
4. Right of setoff is generally not allowed because the netting of assets against
    liabilities results in the loss of important information about the rights and
    obligations of the company.

F. Analysis of long-term debt.
   1. Solvency: ability to pay interest and principle on long-term debt as it comes
   due.

    2.   Debt to total assets ratio = Total Debt/Total Assets

         (1) The higher the percentage, the greater the risk that the company may
             be unable to pay its maturing debt.

    3.   Times interest earned ratio =
                 Income before income taxes & interest expense
                               Interest expense

         (1) The ability to meet interest payments as they come due.




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