RM CHAPTER
14
LONG-TE LIAB I LITI E S
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 2 3 4 5 6 7 8
Describe the formal procedures associated with issuing long-term debt. Identify various types of bond issues. Describe the accounting valuation for bonds at date of issuance. Apply the methods of bond discount and premium amortization. Describe the accounting for the extinguishment of debt. Explain the accounting for long-term notes payable. Explain the reporting of off-balance-sheet financing arrangements. Indicate how to present and analyze long-term debt.
Your Debt Is Killing My Stock
Traditionally, investors in the stock and bond markets operate in their own separate worlds. However, in recent volatile markets, even quiet murmurs in the bond market have been amplified into movements (usually negative) in stock prices. At one extreme, these gyrations heralded the demise of a company well before the investors could sniff out the problem. The swift decline of Enron in late 2001 provided the ultimate lesson: A company with no credit is no company at all. As one analyst remarked, You can no longer have an opinion on a companys stock without having an appreciation for its credit rating. Other energy companies, such as Calpine, NRG Energy, and AES Corp., also felt the effect of Enrons troubles as lenders tightened or closed down the credit supply and raised interest rates on already-high levels of debt. The result? Stock prices took a hit. Another debt feature that can impact shareholders are bond covenants, which provide bond investors various protections while at the same time constraining management. Such covenants may limit the payment of dividends or preclude the issuance of new debt. In some cases, covenants constrain the company from pursuing certain risky projects or prevent it from selling off assets. Why do companies offer these concessions? It is primarily because
688
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bond investors demand higher rates of return unless they are protected from the risk that the company will reward shareholders at the bondholders expense. A good example is Laboratory Corp. of America. It included a covenant in a recent bond issue offering to buy the bonds back at a premium (referred to as a call provision) if there is a change in control leading to a lowering of the debt rating. Laboratory Corp. apparently felt offering the concession was worth it, since the company needed the proceeds from the debt issue to fund its growth. Other industries are not immune from the negative shareholder effects of credit problems. For example, analysts at TheStreet.com compiled a list of companies with high debt levels and low ability to cover interest costs. Among them is Goodyear Tire and Rubber, which reported debt six times greater than its equity. Goodyear is a classic example of how swift and crippling a heavy debt-load can be. Not too long ago, Goodyear had a good credit rating and was paying a good dividend. But with mounting operating losses, Goodyears debt became a huge burden, its debt rating fell to junk-status, the company cut its dividend, and its stock price dropped 80%. This was yet another example of stock prices taking a hit due to concerns about credit quality. Thus, even if your investment tastes are in stocks, keep an eye on the liabilities. Source: Adapted from Steven Vames, Credit Quality, Stock Investing Seem to Go Hand in Hand, Wall Street Journal (April 1, 2002), p. R4; Herb Greenberg, The Hidden Dangers of Debt, Fortune (July 21, 2003), p. 153; and Christine Richard, Holders of Corporate Bonds Seek Protection From Risk, Wall Street Journal (December 1718, 2005), p. B4.
PREVIEW
OF
CHAPTER
14
As our opening story indicates, investors pay considerable attention to a companys liabilities. The stock market severely punishes companies with high debt levels and the related impact of higher interest costs on income performance. In this chapter we explain the accounting issues related to long-term debt. The content and organization of the chapter are as follows.
LONG-TERM LIABILITIES
B O N D S PAYA B L E
Issuing bonds Types and ratings Valuation Effective-interest method Costs of issuing Extinguishment
LONG-TERM N O T E S PAYA B L E
Notes issued at face value Notes not issued at face value Special situations Mortgage notes payable
R E P O R T I N G A N D A N A LY Z I N G LONG-TERM DEBT
Off-balance-sheet financing Presentation and analysis
689
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690 Chapter 14 Long-Term Liabilities
SECTION 1 BON DS PAYAB LE
Long-term debt consists of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities are examples of long-term liabilities. A corporation, per its bylaws, usually requires approval by the board of directors and the stockholders before bonds or notes can be issued. The same holds true for other types of long-term debt arrangements. Generally, long-term debt has various covenants or restrictions that protect Objective1 both lenders and borrowers. The indenture or agreement often includes the Describe the formal procedures amounts authorized to be issued, interest rate, due date(s), call provisions, propassociated with issuing long-term erty pledged as security, sinking fund requirements, working capital and dividend debt. restrictions, and limitations concerning the assumption of additional debt. Companies should describe these features in the body of the financial statements or the notes if important for a complete understanding of the financial position and the results of operations. Although it would seem that these covenants provide adequate protection to the long-term debtholder, many bondholders suffer considerable losses when companies add more debt to the capital structure. Consider what can happen to bondholders in leveraged buyouts (LBOs), which are usually led by management. In an LBO of RJR Nabisco, for example, solidly rated 938 percent bonds due in 2016 plunged 20 percent in value when management announced the leveraged buyout. Such a loss in value occurs because the additional debt added to the capital structure increases the likelihood of default. Although covenants protect bondholders, they can still suffer losses when debt levels get too high.
ISSUING BONDS
A bond arises from a contract known as a bond indenture. A bond represents a promise to pay: (1) a sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on the maturity amount (face value). Individual bonds are evidenced by a paper certificate and typically have a $1,000 face value. Companies usually make bond interest payments semiannually, although the interest rate is generally expressed as an annual rate. The main purpose of bonds is to borrow for the long term when the amount of capital needed is too large for one lender to supply. By issuing bonds in $100, $1,000, or $10,000 denominations, a company can divide a large amount of longterm indebtedness into many small investing units, thus enabling more than one lender to participate in the loan. A company may sell an entire bond issue to an investment bank which acts as a selling agent in the process of marketing the bonds. In such arrangements, investment banks may either underwrite the entire issue by guaranteeing a certain sum to the company, thus taking the risk of selling the bonds for whatever price they can get (firm underwriting). Or they may sell the bond issue for a commission on the proceeds of the sale (best-efforts underwriting). Alternatively, the issuing company may sell the bonds directly to a large institution, financial or otherwise, without the aid of an underwriter (private placement).
TYPES AND RATINGS OF BONDS
Presented on the next page, we define some of the more common types of bonds found in practice.
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Types and Ratings of Bonds 691
TYPES OF BONDS
SECURED AND UNSECURED BONDS. Secured bonds are backed by a pledge of some sort of collateral. Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are secured by stocks and bonds of other corporations. Bonds not backed by collateral are unsecured. A debenture bond is unsecured. A junk bond is unsecured and also very risky, and therefore pays a high interest rate. Companies often use these bonds to finance leveraged buyouts. TERM, SERIAL BONDS, AND CALLABLE BONDS. Bond issues that mature on a single date are called term bonds; issues that mature in installments are called serial bonds. Serially maturing bonds are frequently used by school or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy. Callable bonds give the issuer the right to call and retire the bonds prior to maturity. CONVERTIBLE, COMMODITY-BACKED, AND DEEP-DISCOUNT BONDS. If bonds are convertible into other securities of the corporation for a specified time after issuance, they are convertible bonds. Two types of bonds have been developed in an attempt to attract capital in a tight money marketcommodity-backed bonds and deep-discount bonds. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity, such as barrels of oil, tons of coal, or ounces of rare metal. To illustrate, Sunshine Mining, a silver-mining company, sold two issues of bonds redeemable with either $1,000 in cash or 50 ounces of silver, whichever is greater at maturity, and that have a stated interest rate of 812 percent. The accounting problem is one of projecting the maturity value, especially since silver has fluctuated between $4 and $40 an ounce since issuance. JCPenney Company sold the first publicly marketed long-term debt securities in the United States that do not bear interest. These deep-discount bonds, also referred to as zero-interest debenture bonds, are sold at a discount that provides the buyers total interest payoff at maturity. REGISTERED AND BEARER (COUPON) BONDS. Bonds issued in the name of the owner are registered bonds and require surrender of the certificate and issuance of a new certificate to complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery. INCOME AND REVENUE BONDS. Income bonds pay no interest unless the issuing company is profitable. Revenue bonds, so called because the interest on them is paid from specified revenue sources, are most frequently issued by airports, school districts, counties, toll-road authorities, and governmental bodies.
Objective2 Identify various types of bond issues.
ALL ABOUT BONDS
How do investors monitor their bond investments? One way is to review the bond listings found in the newspaper or online. Corporate bond listings show the coupon (interest) rate, maturity date, and last price. However, because corporate bonds are more actively held by large institutional investors, the listings also indicate the current yield and the volume traded. Corporate bond listings would look like those below.
Issuer BellSouth Corp. General Motors Corp. Coupon Maturity 6.000 11/15/2034 8.375 07/15/2033 Price: High/Low 102.190 95.370 96.426 86.781 Yield: High/Low 5.839 6.357 8.721 9.779 Volume ($, 000) 23,125 923,072
What do the numbers mean?
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692 Chapter 14 Long-Term Liabilities
What do the numbers mean? (continued)
The companies issuing the bonds are listed in the first column, in this case, a telecommunications company, BellSouth Corp., and the automaker General Motors Corp. Immediately after the names is a column with the interest rate paid by the bond as a percentage of its par value, with its maturity date below. The BellSouth bonds, for example, pay 6 percent and mature on November 15, 2034. The General Motors bonds pay 8.375 percent, quite a bit more. The BellSouth bonds have a current yield of 6.3 percent based on the closing low price of 95.370 per $1,000. The high/low prices are based on trading in a five-day period, in which the volume traded on the exchange amounted to $23,125 million. The General Motors bonds, at the high price of 96.426, yield 8.721 percent. The GM bonds had volume of nearly $1 billion dollars. Also, as indicated in the chapter, interest rates and the bonds term to maturity have a real effect on bond prices. For example, an increase in interest rates will lead to a decline in bond values. Similarly, a decrease in interest rates will lead to a rise in bond values. The data reported below, based on three different bond funds, demonstrate these relationships between interest rate changes and bond values.
Bond Price Changes in Response to Interest Rate Changes Short-term fund (25 years) Intermediate-term fund (5 years) Long-term fund (10 years) Data source: The Vanguard Group. 1% Interest Rate Increase 2.5% 5% 10% 1% Interest Rate Decrease 2.5% 5% 10%
Another factor that affects bond prices is the call feature, which decreases the value of the bond. Investors must be rewarded for the risk that the issuer will call the bond if interest rates decline, which would force the investor to reinvest at lower rates.
Source: The Bond Market Association (www.investinginbonds.com) (accessed March 2007).
VALUATION OF BONDS PAYABLEDISCOUNT AND PREMIUM
The issuance and marketing of bonds to the public does not happen overnight. It usually takes weeks or even months. First, the issuing company must arrange for underwriters that will help market and sell the bonds. Then it must obtain the Securities and Exchange Commissions approval of the bond issue, undergo audits, and issue a prospectus (a document which describes the features of the bond and related financial information). Finally, the company must generally have the bond certificates printed. Frequently the issuing company establishes the terms of a bond indenture well in advance of the sale of the bonds. Between the time the company sets these terms and the time it issues the bonds, the market conditions and the financial position of the issuing corporation may change significantly. Such changes affect the marketability of the bonds and thus their selling price. The selling price of a bond issue is set by the supply and demand of buyers and sellers, relative risk, market conditions, and the state of the economy. The investment community values a bond at the present value of its expected future cash flows, which consist of (1) interest and (2) principal. The rate used to compute the present value I NTERNATIONAL of these cash flows is the interest rate that provides an acceptable return on an inI NSIGHT vestment commensurate with the issuers risk characteristics. Both iGAAP and U.S. GAAP The interest rate written in the terms of the bond indenture (and often printed permit valuation of long-term debt and on the bond certificate) is known as the stated, coupon, or nominal rate. The issuer other liabilities at fair value with gains of the bonds sets this rate. The stated rate is expressed as a percentage of the face and losses on changes in fair value value of the bonds (also called the par value, principal amount, or maturity value). recorded in income (referred to as the If the rate employed by the investment community (buyers) differs from the fair value option) in certain situations. stated rate, the present value of the bonds computed by the buyers (and the current
Objective3 Describe the accounting valuation for bonds at date of issuance.
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Valuation of Bonds PayableDiscount and Premium 693 purchase price) will differ from the face value of the bonds. The difference between the face value and the present value of the bonds determines the actual price that buyers pay for the bonds. This difference is either a discount or premium.1 If the bonds sell for less than face value, they sell at a discount. If the bonds sell for more than face value, they sell at a premium. The rate of interest actually earned by the bondholders is called the effective yield or market rate. If bonds sell at a discount, the effective yield exceeds the stated rate. Conversely, if bonds sell at a premium, the effective yield is lower than the stated rate. Several variables affect the bonds price while it is outstanding, most notably the market rate of interest. There is an inverse relationship between the market interest rate and the price of the bond. Here we consider an example to illustrate the computation of the present value of a bond issue. Assume that ServiceMaster issues $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. The time diagram in Illustration 14-1 depicts both the interest and the principal cash flows.
ILLUSTRATION 14-1 Time Diagram for Bond Cash Flows
PV i = 11% PVOA $9,000 $9,000 $9,000 $9,000
$100,000 Principal $9,000 Interest
0
1
2 n=5
3
4
5
The actual principal and interest cash flows are discounted at an 11 percent rate for five periods as shown in Illustration 14-2.
Present value of the principal: $100,000 .59345 (Table 6-2) Present value of the interest payments: $9,000 3.69590 (Table 6-4) Present value (selling price) of the bonds
$59,345.00 33,263.10 $92,608.10
ILLUSTRATION 14-2 Present Value Computation of Bond Selling at a Discount
By paying $92,608.10 at the date of issue, investors realize an effective rate or yield of 11 percent over the five-year term of the bonds. These bonds would sell at a discount of $7,391.90 ($100,000 $92,608.10). The price at which the bonds sell is typically stated as a percentage of the face or par value of the bonds. For example, the ServiceMaster bonds sold for 92.6 (92.6% of par). If ServiceMaster had received $102,000, then the bonds sold for 102 (102% of par). When bonds sell at less than face value, it means that investors demand a rate of interest higher than the stated rate. Usually this occurs because the investors can earn a greater rate on alternative investments of equal risk. They cannot change the stated rate, so they refuse to pay face value for the bonds. Thus, by changing the amount invested, they alter the effective rate of return. The investors receive interest at the stated rate computed on the face value, but they actually earn at an effective rate that exceeds the stated rate because they paid less than face value for the bonds. (Later in the chapter, in Illustrations 14-6 and 14-7, we show an illustration for a bond that sells at a premium.)
1
It is generally the case that the stated rate of interest on bonds is set in rather precise decimals (such as 10.875 percent). Companies usually attempt to align the stated rate as closely as possible with the market or effective rate at the time of issue.
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694 Chapter 14 Long-Term Liabilities
HOWS MY RATING?
Two major publication companies, Moodys Investors Service and Standard & Poors Corporation, issue quality ratings on every public debt issue. The following table summarizes the ratings issued by Standard & Poors, along with historical default rates on bonds with different ratings. As expected, bonds receiving the highest quality rating of AAA have the lowest historical default rates. Bonds rated below BBB, which are considered below investment grade (junk bonds), experience default rates ranging from 20 to 50 percent.
Original rating Default rate AAA 0.52% AA 1.31 A 2.32 BBB 6.64 BB 19.52 B 35.76 CCC 54.38
What do the numbers mean?
Data source: Standard & Poors Corp.
Debt ratings reflect credit quality. The market closely monitors these ratings when determining the required yield and pricing of bonds at issuance and in periods after issuance, especially if a bonds rating is upgraded or downgraded. Data on recent downgrades suggest that the number of fallen angels (downgraded debt) is on the rise.
(Issuers) 90 80 500 70 60 50 300 40 30 20 100 10 0 200 400
Par Bonds Affected Number of Issuers
(US$ Billion) 600
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007(est.)
Source: Standard & Poors Global Fixed Income Research (February 6, 2007).
As recently as 1999, the number and amount of upgrades exceeded downgrades. However, following a decline in 2003, the number of fallen angels increased from 20042006, and 2007 is estimated to come in at record levels. It is not surprising, then, that bond investors and companies who issue bonds keep a close watch on debt ratingsboth when bonds are issued and while the bonds are outstanding.
Source: A. Borrus, M. McNamee, and H. Timmons, The Credit Raters: How They Work and How They Might Work Better, Business Week (April 8, 2002), pp. 3840; Standard and Poors, Global Fixed Income Research, Fallen Angel Activity (February 6, 2007); and S. Scholtes, Bondholders Seek Stability, Financial Times (December 19, 2007), p. 38.
Bonds Issued at Par on Interest Date
When a company issues bonds on an interest payment date at par (face value), it accrues no interest. No premium or discount exists. The company simply records the cash proceeds and the face value of the bonds. To illustrate, if Buchanan Company issues at par 10-year term bonds with a par value of $800,000, dated January 1, 2010, and bearing
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Valuation of Bonds PayableDiscount and Premium 695 interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the following entry:
Cash Bonds Payable 800,000 800,000
.10
Buchanan records the first semiannual interest payment of $40,000 ($800,000 1/2) on July 1, 2010, as follows.
Bond Interest Expense Cash 40,000 40,000
It records accrued interest expense at December 31, 2010 (year-end) as follows.
Bond Interest Expense Bond Interest Payable 40,000 40,000
Bonds Issued at Discount or Premium on Interest Date
If Buchanan Company issues the $800,000 of bonds on January 1, 2010, at 97 (meaning 97 percent of par), it records the issuance as follows.
Cash ($800,000 .97) Discount on Bonds Payable Bonds Payable 776,000 24,000 800,000
Objective4 Apply the methods of bond discount and premium amortization.
Recall from our earlier discussion that because of its relation to interest, companies amortize the discount and charge it to interest expense over the period of time that the bonds are outstanding. The straight-line method amortizes a constant amount each interest period (in this case 20 interest periods).2 For example, using the bond discount of $24,000, Buchanan amortizes $1,200 to interest expense each period for 20 periods ($24,000 20). Buchanan records the first semiannual interest payment of $40,000 ($800,000 10% 1 2) and the bond discount on July 1, 2010 as follows: /
Bond Interest Expense Discount on Bonds Payable Cash 41,200 1,200 40,000
At December 31, 2010, Buchanan makes the following adjusting entry:
Bond Interest Expense Discount on Bonds Payable Bond Interest Payable 41,200 1,200 40,000
At the end of the first year, 2010, the balance in the Discount on Bonds Payable account is $21,600 ($24,000 $1,200 $1,200). Over the term of the bonds, the balance in the Discount on Bonds Payable will decrease by the same amount until it has zero balance at the maturity date of the bonds. If instead of issuing the bonds on January 1, 2010, Buchanan dates and sells the bonds on October 1, 2010, and if the fiscal year of the corporation ends on December 31, the discount amortized during 2010 would be only 3/12 of 1/10 of $24,000, or $600. Buchanan must also record three months of accrued interest on December 31. Premium on Bonds Payable is accounted for in a manner similar to that for Discount on Bonds Payable. If Buchanan dates and sells 10-year bonds with a par value of $800,000 on January 1, 2010, at 103, it records the issuance as follows.
Cash ($800,000 1.03) Premium on Bonds Payable Bonds Payable
2
824,000 24,000 800,000
The effective-interest method is preferred for amortization of discount or premium. To keep these initial illustrations simple, we have chosen to use the straight-line method.
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696 Chapter 14 Long-Term Liabilities With the bond premium of $24,000, Buchanan amortizes $1,200 to interest expense each period for 20 periods ($24,000 20). Buchanan records the first semiannual interest payment of $40,000 ($800,000 10% 1 2) and the bond premium on July 1, 2010 as follows: /
Bond Interest Expense Premium on Bonds Payable Cash 38,800 1,200 40,000
At December 31, 2010, Buchanan makes the following adjusting entry:
Bond Interest Expense Premium on Bonds Payable Bond Interest Payable 38,800 1,200 40,000
Amortization of a discount increases bond interest expense. Amortization of a premium decreases bond interest expense. Later in the chapter we discuss amortization of a discount or premium under the effective-interest method. The issuer may call some bonds at a stated price after a certain date. This call feature gives the issuing corporation the opportunity to reduce its bonded indebtedness or take advantage of lower interest rates. Whether callable or not, a company must amortize any premium or discount over the bonds life to maturity because early redemption (call of the bond) is not a certainty.
Bonds Issued Between Interest Dates
Companies usually make bond interest payments semiannually, on dates specified in the bond indenture. When companies issue bonds on other than the interest payment dates, buyers of the bonds will pay the seller the interest accrued from the last interest payment date to the date of issue. The purchasers of the bonds, in effect, pay the bond issuer in advance for that portion of the full six-months interest payment to which they are not entitled because they have not held the bonds for that period. Then, on the next semiannual interest payment date, purchasers will receive the full sixmonths interest payment. To illustrate, assume that on March 1, 2010, Taft Corporation issues 10-year bonds, dated January 1, 2010, with a par value of $800,000. These bonds have an annual interest rate of 6 percent, payable semiannually on January 1 and July 1. Because Taft issues the bonds between interest dates, it records the bond issuance at par plus accrued interest as follows.
Cash Bonds Payable Bond Interest Expense ($800,000 .06 2/12) (Interest Payable might be credited instead) 808,000 800,000 8,000
The purchaser advances two months interest. On July 1, 2010, four months after the date of purchase, Taft pays the purchaser six months interest. Taft makes the following entry on July 1, 2010.
Bond Interest Expense Cash 24,000 24,000
The Bond Interest Expense account now contains a debit balance of $16,000, which represents the proper amount of interest expensefour months at 6 percent on $800,000. The illustration above was simplified by having the January 1, 2010, bonds issued on March 1, 2010, at par. If, however, Taft issued the 6 percent bonds at 102, its March 1 entry would be:
Cash [($800,000 1.02) ($800,000 .06 2/12)] Bonds Payable Premium on Bonds Payable ($800,000 .02) Bond Interest Expense 824,000 800,000 16,000 8,000
Taft would amortize the premium from the date of sale (March 1, 2010), not from the date of the bonds (January 1, 2010).
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Effective-Interest Method 697
EFFECTIVE-INTEREST METHOD
The preferred procedure for amortization of a discount or premium is the effectiveinterest method (also called present value amortization). Under the effective-interest method, companies:
1. Compute bond interest expense first by multiplying the carrying value (book value) of the bonds at the beginning of the period by the effective interest rate.3 2. Determine the bond discount or premium amortization next by comparing the bond interest expense with the interest (cash) to be paid.
Illustration 14-3 depicts graphically the computation of the amortization.
Bond Interest Expense Carrying Value of Bonds at Beginning of Period
Bond Interest Paid
Effective Interest Rate
Face Amount of Bonds
Stated Interest Rate
=
Amortization Amount
ILLUSTRATION 14-3 Bond Discount and Premium Amortization Computation
The effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. Since the percentage is the effective rate of interest incurred by the borrower at the time of issuance, the effectiveinterest method matches expenses with revenues better than the straight-line method. Both the effective-interest and straight-line methods result in the same total amount of interest expense over the term of the bonds. However, when the annual amounts are materially different, generally accepted accounting principles require use of the effective-interest method. [1]
See the FASB Codification section (page 723).
Bonds Issued at a Discount
To illustrate amortization of a discount under the effective-interest method, Evermaster Corporation issued $100,000 of 8 percent term bonds on January 1, 2010, due on January 1, 2015, with interest payable each July 1 and January 1. Because the investors required an effective-interest rate of 10 percent, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. Evermaster computes the $7,722 discount as follows.4
Maturity value of bonds payable Present value of $100,000 due in 5 years at 10%, interest payable semiannually (Table 6-2); FV(PVF10,5%); ($100,000 .61391) Present value of $4,000 interest payable semiannually for 5 years at 7.72173) 10% annually (Table 6-4); R(PVF-OA10,5%); ($4,000 Proceeds from sale of bonds Discount on bonds payable
$100,000 $61,391 30,887 92,278 $ 7,722
ILLUSTRATION 14-4 Computation of Discount on Bonds Payable
3
The carrying value is the face amount minus any unamortized discount or plus any unamortized premium. The term carrying value is synonymous with book value.
6
Because companies pay interest semiannually, the interest rate used is 5% (10% The number of periods is 10 (5 years 2).
4
12).
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698 Chapter 14 Long-Term Liabilities The five-year amortization schedule appears in Illustration 14-5.
ILLUSTRATION 14-5 Bond Discount Amortization Schedule
Calculator Solution for Present Value of Bonds: Inputs Answer
SCHEDULE OF BOND DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHODSEMIANNUAL INTEREST PAYMENTS 5-YEAR, 8% BONDS SOLD TO YIELD 10% Cash Paid $ 4,000a 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 $40,000
a
Date 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 7/1/12 1/1/13 7/1/13 1/1/14 7/1/14 1/1/15
Interest Expense $ 4,614b 4,645 4,677 4,711 4,746 4,783 4,823 4,864 4,907 4,952 $47,722
6/12 6/12
c
Discount Amortized $ 614c 645 677 711 746 783 823 864 907 952 $7,722
Carrying Amount of Bonds $ 92,278 92,892d 93,537 94,214 94,925 95,671 96,454 97,277 98,141 99,048 100,000
N I/YR PV PMT FV
10
5
?
92,278
4,000 $4,000 $4,614
100,000
b
$100,000 .08 $92,278 .10
d
$614 $4,614 $4,000 $92,892 $92,278 $614
Evermaster records the issuance of its bonds at a discount on January 1, 2010, as follows:
Cash Discount on Bonds Payable Bonds Payable 92,278 7,722 100,000
It records the first interest payment on July 1, 2010, and amortization of the discount as follows:
Bond Interest Expense Discount on Bonds Payable Cash 4,614 614 4,000
Evermaster records the interest expense accrued at December 31, 2010 (year-end) and amortization of the discount as follows:
Bond Interest Expense Bond Interest Payable Discount on Bonds Payable 4,645 4,000 645
Bonds Issued at a Premium
Now assume that for the bond issue described above, investors are willing to accept an effective interest rate of 6 percent. In that case, they would pay $108,530 or a premium of $8,530, computed as follows.
ILLUSTRATION 14-6 Computation of Premium on Bonds Payable
Maturity value of bonds payable Present value of $100,000 due in 5 years at 6%, interest payable semiannually (Table 6-2); FV(PVF10,3%); ($100,000 .74409) Present value of $4,000 interest payable semiannually for 5 years at 8.53020) 6% annually (Table 6-4); R(PVF-OA10,3%); ($4,000 Proceeds from sale of bonds Premium on bonds payable
$100,000 $74,409 34,121 108,530 $ 8,530
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Effective-Interest Method 699 The five-year amortization schedule appears in Illustration 14-7.
SCHEDULE OF BOND PREMIUM AMORTIZATION EFFECTIVE-INTEREST METHODSEMIANNUAL INTEREST PAYMENTS 5-YEAR, 8% BONDS SOLD TO YIELD 6% Cash Paid $ 4,000a 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 $40,000
a
ILLUSTRATION 14-7 Bond Premium Amortization Schedule
Calculator Solution for Present Value of Bonds: Inputs Answer
Date 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 7/1/12 1/1/13 7/1/13 1/1/14 7/1/14 1/1/15
Interest Expense $ 3,256b 3,234 3,211 3,187 3,162 3,137 3,112 3,085 3,057 3,029 $31,470 .08 .06 6/12 6/12
c
Premium Amortized $ 744c 766 789 813 838 863 888 915 943 971 $8,530
Carrying Amount of Bonds $108,530 107,786d 107,020 106,231 105,418 104,580 103,717 102,829 101,914 100,971 100,000
N I/YR PV PMT FV
10
3
?
108,530
4,000
b
$4,000 $3,256
$100,000 $108,530
d
$744 $4,000 $3,256 $107,786 $108,530 $744
100,000
Evermaster records the issuance of its bonds at a premium on January 1, 2010, as follows:
Cash Premium on Bonds Payable Bonds Payable 108,530 8,530 100,000
Evermaster records the first interest payment on July 1, 2010, and amortization of the premium as follows:
Bond Interest Expense Premium on Bonds Payable Cash 3,256 744 4,000
Evermaster should amortize the discount or premium as an adjustment to interest expense over the life of the bond in such a way as to result in a constant rate of interest when applied to the carrying amount of debt outstanding at the beginning of any given period.
Accruing Interest
In our previous examples, the interest payment dates and the date the financial statements were issued were the same. For example, when Evermaster sold bonds at a premium (page 698), the two interest payment dates coincided with the financial reporting dates. However, what happens if Evermaster wishes to report financial statements at the end of February 2010? In this case, the company prorates the premium by the appropriate number of months, to arrive at the proper interest expense, as follows.
2 Interest accrual ($4,000 6) 2 6) Premium amortized ($744
$1,333.33 (248.00) $1,085.33
Interest expense (Jan.Feb.)
ILLUSTRATION 14-8 Computation of Interest Expense
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700 Chapter 14 Long-Term Liabilities Evermaster records this accrual as follows.
Bond Interest Expense Premium on Bonds Payable Bond Interest Payable 1,085.33 248.00 1,333.33
If the company prepares financial statements six months later, it follows the same procedure. That is, the premium amortized would be as follows.
ILLUSTRATION 14-9 Computation of Premium Amortization
Premium amortized (MarchJune) ($744 Premium amortized (JulyAugust) ($766 Premium amortized (MarchAugust 2004)
4 2
6) 6)
$496.00 255.33 $751.33
The interest-accrual computation is much simpler if the company uses the straightline method. For example, the total premium is $8,530, which Evermaster allocates evenly over the five-year period. Thus, premium amortization per month is $142.17 ($8,530 60 months).
Classification of Discount and Premium
Discount on bonds payable is not an asset. It does not provide any future economic benefit. In return for the use of borrowed funds, a company must pay interest. A bond discount means that the company borrowed less than the face or maturity value of the bond. It therefore faces an actual (effective) interest rate higher than the stated (nominal) rate. Conceptually, discount on bonds payable is a liability valuation account. That is, it reduces the face or maturity amount of the related liability.5 This account is referred to as a contra account. Similarly, premium on bonds payable has no existence apart from the related debt. The lower interest cost results because the proceeds of borrowing exceed the face or maturity amount of the debt. Conceptually, premium on bonds payable is a liability valuation account. It adds to the face or maturity amount of the related liability.6 This account is referred to as an adjunct account. As a result, companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond.
COSTS OF ISSUING BONDS
The issuance of bonds involves engraving and printing costs, legal and accounting fees, commissions, promotion costs, and other similar charges. Companies are required to charge these costs to an asset account, often referred to as Unamortized Bond Issue Costs. Companies then allocate these Unamortized Bond Issue Costs over the life of the debt, in a manner similar to that used for discount on bonds. [2] We disagree with this approach. Unamortized bond issue cost in our view is an expense (or a reduction of the related liability). Apparently the FASB also disagrees with the current GAAP treatment and notes in Concepts Statement No. 6 that debt issue cost is not considered an asset because it provides no future economic benefit. The cost of issuing bonds, in effect, reduces the proceeds of the bonds issued and increases the effective interest rate. Companies may thus account for it the same as the unamortized discount. There is an obvious difference between GAAP and Concepts Statement No. 6s view of debt issue costs. However, until an issued standard supersedes existing GAAP, unamortized bond issue costs are treated as a deferred charge and amortized over the life of the debt.
5
Elements of Financial Statements of Business Enterprises, Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1980). Ibid., par. 238.
6
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Extinguishment of Debt 701 To illustrate the accounting for costs of issuing bonds, assume that Microchip Corporation sold $20,000,000 of 10-year debenture bonds for $20,795,000 on January 1, 2010 (also the date of the bonds). Costs of issuing the bonds were $245,000. Microchip records the issuance of the bonds and amortization of the bond issue costs as follows.
January 1, 2010 Cash Unamortized Bond Issue Costs Premium on Bonds Payable Bonds Payable (To record issuance of bonds) December 31, 2010 Bond Issue Expense Unamortized Bond Issue Costs (To amortize one year of bond issue costsstraight-line method) 24,500 24,500 20,550,000 245,000 795,000 20,000,000
Microchip continues to amortize the bond issue costs in the same way over the life of the bonds. Although the effective-interest method is preferred, in practice companies may use the straight-line method to amortize bond issue costs because it is easier and the results are not materially different.
EXTINGUISHMENT OF DEBT
How do companies record the payment of debtoften referred to as extinguishObjective5 ment of debt? If a company holds the bonds (or any other form of debt security) Describe the accounting for the to maturity, the answer is straightforward: The company does not compute any extinguishment of debt. gains or losses. It will have fully amortized any premium or discount and any issue costs at the date the bonds mature. As a result, the carrying amount will equal the maturity (face) value of the bond. As the maturity or face value will also equal the bonds market value at that time, no gain or loss exists. In some cases, a company extinguishes debt before its maturity date.7 The amount paid on extinguishment or redemption before maturity, including any call premium and expense of reacquisition, is called the reacquisition price. On any specified date, the net carrying amount of the bonds is the amount payable at maturity, adjusted for unamortized premium or discount, and cost of issuance. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the net carrying amount is a loss from extinguishment. At the time of reacquisition, the unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date. To illustrate, assume that on January 1, 2003, General Bell Corp. issued at 97 bonds with a par value of $800,000, due in 20 years. It incurred bond issue costs totaling $16,000. Eight years after the issue date, General Bell calls the entire issue at 101 and cancels it.8 At that time, the unamortized discount balance is $14,400, and the unamortized
7
Some companies have attempted to extinguish debt through an in-substance defeasance. In-substance defeasance is an arrangement whereby a company provides for the future repayment of a long-term debt issue by placing purchased securities in an irrevocable trust. The company pledges the principal and interest of the securities in the trust to pay off the principal and interest of its own debt securities as they mature. However, it is not legally released from its primary obligation for the debt that is still outstanding. In some cases, debt holders are not even aware of the transaction and continue to look to the company for repayment. This practice is not considered an extinguishment of debt, and therefore the company does not record a gain or loss. The issuer of callable bonds must generally exercise the call on an interest date. Therefore, the amortization of any discount or premium will be up to date, and there will be no accrued interest. However, early extinguishments through purchases of bonds in the open market are more likely to be on other than an interest date. If the purchase is not made on an interest date, the discount or premium must be amortized, and the interest payable must be accrued from the last interest date to the date of purchase.
8
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702 Chapter 14 Long-Term Liabilities issue cost balance is $9,600. Illustration 14-10 indicates how General Bell computes the loss on redemption (extinguishment).
ILLUSTRATION 14-10 Computation of Loss on Redemption of Bonds
Reacquisition price ($800,000 1.01) Net carrying amount of bonds redeemed: Face value Unamortized discount ($24,000* 12/20) Unamortized issue costs ($16,000 12/20) (both amortized using straight-line basis) Loss on redemption
*[$800,000 (1 .97)]
$808,000 $800,000 (14,400) (9,600) 776,000 $ 32,000
General Bell records the reacquisition and cancellation of the bonds as follows:
Bonds Payable Loss on Redemption of Bonds Discount on Bonds Payable Unamortized Bond Issue Costs Cash 800,000 32,000 14,400 9,600 808,000
Note that it is often advantageous for the issuer to acquire the entire outstanding bond issue and replace it with a new bond issue bearing a lower rate of interest. The replacement of an existing issuance with a new one is called refunding. Whether the early redemption or other extinguishment of outstanding bonds is a nonrefunding or a refunding situation, a company should recognize the difference (gain or loss) between the reacquisition price and the net carrying amount of the redeemed bonds in income of the period of redemption.9
DEAD-WEIGHT DEBT
As the opening story in the chapter indicated, high debt levels translate into high interest costs, which are a drag on profitability. The chart below shows that the ratio of interest payments to earnings has been on an upward trend. This is bad news for companies that have a lot of debt on their balance sheet.
What do the numbers mean?
Debt service vs. profits 40%
30
20 Ratio of net interest payments to earnings* 10
0 1996
1997
1998
1999
2000
2001
2002
*Earnings before tax and interest Data: HSBC Securities Inc., Commerce Dept.
9
Companies at one time reported gains and losses on extinguishment of debt as extraordinary items. In response to concerns that such gains or losses are neither unusual nor infrequent, the FASB eliminated extraordinary item treatment for extinguishment of debt. [3]
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Notes Issued at Face Value 703
However, in a low interest rate environment, as experienced at least through 2008, companies with debt-laden balance sheets benefit when interest rates fall. Exelon Corp., a Chicago-based energy company, is a good example. Exelon has been refinancing its long-term debt by retiring bonds with 6.5 percent rates in exchange for newly issued bonds with rates ranging from 3.7 percent to 5.9 percent. This refinancing saved Exelon approximately $30 million dollars in annual interest costs. Exelon was able to get out of its higher cost debt when the getting was good. Other debt-laden companies might not fare so well if interest rates rise before they can refinance.
Source: Adapted from Gregory Zuckerman, Climb of Corporate Debt Trips Analysts Alarm, Wall Street Journal (December 31, 2001), p. C1; and James Mehring, The Dead Weight of Debt, Business Week (February 24, 2003), p. 60.
What do the numbers mean? (continued)
SECTION 2 LONG-TERM NOTES PAYAB LE
The difference between current notes payable and long-term notes payable is the Objective6 maturity date. As discussed in Chapter 13, short-term notes payable are those that Explain the accounting for long-term companies expect to pay within a year or the operating cyclewhichever is longer. notes payable. Long-term notes are similar in substance to bonds in that both have fixed maturity dates and carry either a stated or implicit interest rate. However, notes do not trade as readily as bonds in the organized public securities markets. Noncorporate and small corporate enterprises issue notes as their long-term instruments. Larger corporations issue both long-term notes and bonds. Accounting for notes and bonds is quite similar. Like a bond, a note is valued at the present value of its future interest and principal cash flows. The company amortizes any discount or premium over the life of the note, just as it would the discount or premium on a bond.10 Companies compute the present value of an interest-bearing note, record its issuance, and amortize any discount or premium and accrual of interest in the same way that they do for bonds (as shown on pages 692700 of this chapter). As you might expect, accounting for long-term notes payable parallels accounting for long-term notes receivable as was presented in Chapter 7.
NOTES ISSUED AT FACE VALUE
In Chapter 7, we discussed the recognition of a $10,000, three-year note Scandinavian Imports issued at face value to Bigelow Corp. In this transaction, the stated rate and the effective rate were both 10 percent. The time diagram and present value computation on page 332 of Chapter 7 (see Illustration 7-9) for Bigelow Corp. would be the same for the issuer of the note, Scandinavian Imports, in recognizing a note payable. Because the present value of the note and its face value are the same, $10,000, Scandinavian would recognize no premium or discount. It records the issuance of the note as follows.
Cash Notes Payable 10,000 10,000
10
All payables that represent commitments to pay money at a determinable future date are subject to present value measurement techniques, except for the following specifically excluded types: 1. 2. 3. 4. Normal accounts payable due within one year. Security deposits, retainages, advances, or progress payments. Transactions between parent and subsidiary. Obligations payable at some indeterminable future date. [4]
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704 Chapter 14 Long-Term Liabilities Scandinavian Imports would recognize the interest incurred each year as follows.
Interest Expense Cash 1,000 1,000
NOTES NOT ISSUED AT FACE VALUE
Zero-Interest-Bearing Notes
Calculator Solution for Effective Interest on Note: Inputs Answer
N I/YR PV PMT FV
8
?
15
-327
0
1,000
If a company issues a zero-interest-bearing (non-interest-bearing) note11 solely for cash, it measures the notes present value by the cash received. The implicit interest rate is the rate that equates the cash received with the amounts to be paid in the future. The issuing company records the difference between the face amount and the present value (cash received) as a discount and amortizes that amount to interest expense over the life of the note. An example of such a transaction is Beneficial Corporations offering of $150 million of zero-coupon notes (deep-discount bonds) having an eight-year life. With a face value of $1,000 each, these notes sold for $327a deep discount of $673 each. The present value of each note is the cash proceeds of $327. We can calculate the interest rate by determining the rate that equates the amount the investor currently pays with the amount to be received in the future. Thus, Beneficial amortizes the discount over the eight-year life of the notes using an effective interest rate of 15 percent.12 To illustrate the entries and the amortization schedule, assume that Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Company illustrated on page 333 of Chapter 7 (notes receivable). 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. (The present value of $1 for 3 periods at 9 percent is $0.77218.) Illustration 14-11 shows the time diagram for the single cash flow.
ILLUSTRATION 14-11 Time Diagram for Zero-Interest Note
PV i = 9% PVOA $0 $0
$10,000 Principal $0 Interest
0
1 n=3
2
3
Turtle Cove records issuance of the note as follows.
Cash Discount on Notes Payable Notes Payable 7,721.80 2,278.20 10,000.00
Turtle Cove amortizes the discount and recognizes interest expense annually using the effective-interest method. Illustration 14-12 (on page 705) shows the three-year discount amortization and interest expense schedule. (This schedule is similar to the note receivable schedule of Jeremiah Company in Illustration 7-11.)
11
Although we use the term note throughout this discussion, the basic principles and methodology apply equally to other long-term debt instruments. $327 $1,000(PVF8,i) $327 $1,000 .327
12
PVF8,i .327
15% (in Table 6-2 locate .32690).
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Notes Not Issued at Face Value 705
SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 0% NOTE DISCOUNTED AT 9% Cash Paid Date of issue End of year 1 End of year 2 End of year 3 $0 0 0 $0
a
ILLUSTRATION 14-12 Schedule of Note Discount Amortization
Carrying Amount of Note $ 7,721.80 8,416.76c 9,174.27 10,000.00
Interest Expense $ 694.96a 757.51 825.73d $2,278.20
c
Discount Amortized $ 694.96b 757.51 825.73 $2,278.20
b
$7,721.80 .09 $694.96 $694.96 0 $694.96
d
$7,721.80 $694.96 $8,416.76 5 adjustment to compensate for rounding
Turtle Cove records interest expense at the end of the first year using the effectiveinterest method as follows.
Interest Expense ($7,721.80 9%) Discount on Notes Payable 694.96 694.96
The total amount of the discount, $2,278.20 in this case, represents the expense that Turtle Cove Company will incur on the note over the three years.
Interest-Bearing Notes
The zero-interest-bearing note above is an example of the extreme difference between the stated rate and the effective rate. In many cases, the difference between these rates is not so great. Consider the example from Chapter 7 where Marie Co. issued for cash a $10,000, three-year note bearing interest at 10 percent to Morgan Corp. The market rate of interest for a note of similar risk is 12 percent. Illustration 7-12 (page 334) shows the time diagram depicting the cash flows and the computation of the present value of this note. In this case, because the effective rate of interest (12%) is greater than the stated rate (10%), the present value of the note is less than the face value. That is, the note is exchanged at a discount. Marie Co. records the issuance of the note as follows.
Cash Discount on Notes Payable Notes Payable 9,520 480 10,000
Marie Co. then amortizes the discount and recognizes interest expense annually using the effective-interest method. Illustration 14-13 shows the three-year discount amortization and interest expense schedule.
ILLUSTRATION 14-13 Schedule of Note Discount Amortization
Carrying Amount of Note $ 9,520 9,662d 9,821 10,000
SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 10% NOTE DISCOUNTED AT 12% Cash Paid Date of issue End of year 1 End of year 2 End of year 3 $1,000a 1,000 1,000 $3,000
a
Interest Expense $1,142b 1,159 1,179 $3,480
c
Discount Amortized $142c 159 179 $480
$1,000 $142 $142 $9,662
b
$10,000 $9,520
10% 12%
$1,000 $1,142
d
$1,142 $9,520
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706 Chapter 14 Long-Term Liabilities Marie Co. records payment of the annual interest and amortization of the discount for the first year as follows (amounts per amortization schedule).
Interest Expense Discount on Notes Payable Cash 1,142 142 1,000
When the present value exceeds the face value, Marie Co. exchanges the note at a premium. It does so by recording the premium as a credit and amortizing it using the effective-interest method over the life of the note as annual reductions in the amount of interest expense recognized.
SPECIAL NOTES PAYABLE SITUATIONS
Notes Issued for Property, Goods, or Services
Sometimes, companies may receive property, goods, or services in exchange for a note payable. When exchanging the debt instrument for property, goods, or services in a bargained transaction entered into at arms length, the stated interest rate is presumed to be fair unless:
1. No interest rate is stated, or 2. The stated interest rate is unreasonable, or 3. The stated face amount of the debt instrument is materially different from the current cash sales price for the same or similar items or from the current fair value of the debt instrument.
In these circumstances the company measures the present value of the debt instrument by the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note. [5] If there is no stated rate of interest, the amount of interest is the difference between the face amount of the note and the fair value of the property. For example, assume that Scenic Development Company sells land having a cash sale price of $200,000 to Health Spa, Inc. In exchange for the land, Health Spa gives a five-year, $293,866, zero-interest-bearing note. The $200,000 cash sale price represents the present value of the $293,866 note discounted at 8 percent for five years. Should both parties record the transaction on the sale date at the face amount of the note, which is $293,866? Noif they did, Health Spas Land account and Scenics sales would be overstated by $93,866 (the interest for five years at an effective rate of 8 percent). Similarly, interest revenue to Scenic and interest expense to Health Spa for the five-year period would be understated by $93,866. Because the difference between the cash sale price of $200,000 and the $293,866 face amount of the note represents interest at an effective rate of 8 percent, the companies transaction is recorded at the exchange date as follows.
ILLUSTRATION 14-14 Entries for Noncash Note Transactions
Health Spa, Inc. (Buyer) Land Discount on Notes Payable Notes Payable 200,000 93,866 293,866 Scenic Development Company (Seller) Notes Receivable Discount on Notes Rec. Sales 293,866 93,866 200,000
During the five-year life of the note, Health Spa amortizes annually a portion of the discount of $93,866 as a charge to interest expense. Scenic Development records interest revenue totaling $93,866 over the five-year period by also amortizing the discount. The effective-interest method is required, unless the results obtained from using another method are not materially different from those that result from the effectiveinterest method.
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Special Notes Payable Situations 707
Choice of Interest Rate
In note transactions, the effective or market interest rate is either evident or determinable by other factors involved in the exchange, such as the fair value of what is given or received. But, if a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, the problem of determining the present value of the note is more difficult. To estimate the present value of a note under such circumstances, a company must approximate an applicable interest rate that may differ from the stated interest rate. This process of interest-rate approximation is called imputation, and the resulting interest rate is called an imputed interest rate. The prevailing rates for similar instruments of issuers with similar credit ratings affect the choice of a rate. Other factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate also play a part. Companies determine the imputed interest rate when they issue a note; any subsequent changes in prevailing interest rates are ignored. To illustrate, assume that on December 31, 2010, Wunderlich Company issued a promissory note to Brown Interiors Company for architectural services. The note has a face value of $550,000, a due date of December 31, 2015, and bears a stated interest rate of 2 percent, payable at the end of each year. Wunderlich cannot readily determine the fair value of the architectural services, nor is the note readily marketable. On the basis of Wunderlichs credit rating, the absence of collateral, the prime interest rate at that date, and the prevailing interest on Wunderlichs other outstanding debt, the company imputes an 8 percent interest rate as appropriate in this circumstance. Illustration 14-15 shows the time diagram depicting both cash flows.
ILLUSTRATION 14-15 Time Diagram for Interest-Bearing Note
PV i = 8% PV OA OA $11,000 $11,000 $11,000 $11,000
$550,000 Principal $11,000 Interest
0
1
2 n=5
3
4
5
The present value of the note and the imputed fair value of the architectural services are determined as follows.
Face value of the note Present value of $550,000 due in 5 years at 8% interest payable annually (Table 6-2); FV(PVF5,8%); ($550,000 .68058) Present value of $11,000 interest payable annually for 5 years at 8%; 3.99271) R(PVF-OA5,8%); ($11,000 Present value of the note Discount on notes payable $550,000 $374,319 43,920 418,239 $131,761
ILLUSTRATION 14-16 Computation of Imputed Fair Value and Note Discount
Wunderlich records issuance of the note in payment for the architectural services as follows.
December 31, 2010 Building (or Construction in Process) Discount on Notes Payable Notes Payable 418,239 131,761 550,000
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708 Chapter 14 Long-Term Liabilities The five-year amortization schedule appears below.
ILLUSTRATION 14-17 Schedule of Discount Amortization Using Imputed Interest Rate
Calculator Solution for the Fair Value of Services: Inputs Answer
SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 2% NOTE DISCOUNTED AT 8% (IMPUTED) Cash Paid (2%) $11,000a 11,000 11,000 11,000 11,000 $55,000
a
Date 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
Interest Expense (8%) $ 33,459b 35,256 37,196 39,292 41,558e $186,761
d e
Discount Amortized $ 22,459c 24,256 26,196 28,292 30,558 $131,761
Carrying Amount of Note $418,239 440,698d 464,954 491,150 519,442 550,000
N I/YR PV PMT FV
5
8
?
418,241*
$550,000 2% $11,000 $418,239 8% $33,459 c $33,459 $11,000 $22,459
b
$418,239 $22,459 $440,698 $3 adjustment to compensate for rounding.
11,000
550,000
Wunderlich records payment of the first years interest and amortization of the discount as follows.
December 31, 2011 Interest Expense Discount on Notes Payable Cash 33,459 22,459 11,000
*Difference due to rounding.
MORTGAGE NOTES PAYABLE
The most common form of long-term notes payable is a mortgage note payable. A mortgage note payable is a promissory note secured by a document called a mortgage that pledges title to property as security for the loan. Individuals, proprietorships, and partnerships use mortgage notes payable more frequently than do corporations. (Corporations usually find that bond issues offer advantages in obtaining large loans.) The borrower usually receives cash for the face amount of the mortgage note. In that case, the face amount of the note is the true liability, and no discount or premium is involved. When the lender assesses points, however, the total amount received by the borrower is less than the face amount of the note.13 Points raise the effective interest rate above the rate specified in the note. A point is 1 percent of the face of the note. For example, assume that Harrick Co. borrows $1,000,000, signing a 20-year mortgage note with a stated interest rate of 10.75 percent as part of the financing for a new plant. If Associated Savings demands 4 points to close the financing, Harrick will receive 4 percent less than $1,000,000or $960,000but it will be obligated to repay the entire $1,000,000 at the rate of $10,150 per month. Because Harrick received only $960,000, and must repay $1,000,000, its effective interest rate is increased to approximately 11.3 percent on the money actually borrowed. On the balance sheet, Harrick should report the mortgage note payable as a liability using a title such as Mortgage Notes Payable or Notes PayableSecured, with a brief disclosure of the property pledged in notes to the financial statements. Mortgages may be payable in full at maturity or in installments over the life of the loan. If payable at maturity, Harrick classifies its mortgage payable as a longterm liability on the balance sheet until such time as the approaching maturity date
13
Points, in mortgage financing, are analogous to the original issue discount of bonds.
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Off-Balance-Sheet Financing 709 warrants showing it as a current liability. If it is payable in installments, Harrick shows the current installments due as current liabilities, with the remainder as a long-term liability. Lenders have partially replaced the traditional fixed-rate mortgage with alternative mortgage arrangements. Most lenders offer variable-rate mortgages (also called floating-rate or adjustable-rate mortgages) featuring interest rates tied to changes in the fluctuating market rate. Generally the variable-rate lenders adjust the interest rate at either one- or three-year intervals, pegging the adjustments to changes in the prime rate or the U.S. Treasury bond rate.
SECTION 3 R EPORTI NG AN D ANALYZI NG LO N G-TERM D EBT
Reporting of long-term debt is one of the most controversial areas in financial reporting. Because long-term debt has a significant impact on the cash flows of the company, reporting requirements must be substantive and informative. One problem is that the definition of a liability established in Concepts Statement No. 6 and the recognition criteria established in Concepts Statement No. 5 are sufficiently imprecise that some continue to argue that certain obligations need not be reported as debt.
OFF-BALANCE-SHEET FINANCING
What do Krispy Kreme, Cisco, Enron, and Adelphia Communications have in Objective7 common? They all have been accused of using off-balance-sheet financing to minExplain the reporting of offimize the reporting of debt on their balance sheets. Off-balance-sheet financing balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligaarrangements. tions. It has become an issue of extreme importance. Many allege that Enron, in one of the largest corporate failures on record, hid a considerable amount of its debt off the balance sheet. As a result, any company that uses off-balance-sheet financing today risks investors dumping their stock. Consequently (as discussed in the opening story), their share price will suffer. Nevertheless, a considerable amount of off-balancesheet financing continues to exist. As one writer noted, The basic drives of humans are few: to get enough food, to find shelter, and to keep debt off the balance sheet.
Different Forms
Off-balance-sheet financing can take many different forms:
1. Non-Consolidated Subsidiary: Under GAAP, a parent company does not have to consolidate a subsidiary company that is less than 50 percent owned. In such cases, the parent therefore does not report the assets and liabilities of the subsidiary. All the parent reports on its balance sheet is the investment in the subsidiary. As a result, users of the financial statements may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty. 2. Special Purpose Entity (SPE): A company creates a special purpose entity to perform a special project. To illustrate, assume that Clarke Company decides to build a new factory. However, management does not want to report the plant or the borrowing used to fund the construction on its balance sheet. It therefore creates
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710 Chapter 14 Long-Term Liabilities an SPE, the purpose of which is to build the plant. (This arrangement is called a project financing arrangement.) The SPE finances and builds the plant. In return, Clarke guarantees that it or some outside party will purchase all the products produced by the plant. (Some refer to this as a take-or-pay contract). As a result, Clarke might not report the asset or liability on its books. The accounting rules in this area are complex; we discuss the accounting for SPEs in Appendix 17B. 3. Operating Leases: Another way that companies keep debt off the balance sheet is by leasing. Instead of owning the assets, companies lease them. Again, by meeting certain conditions, the company has to report only rent expense each period and to provide note disclosure of the transaction. Note that SPEs often use leases to accomplish off-balance-sheet treatment. We discuss accounting for lease transactions extensively in Chapter 21.
Rationale
Why do companies engage in off-balance-sheet financing? A major reason is that many believe that removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. Second, loan covenants often limit the amount of debt a company may have. As a result, the company uses off-balance-sheet financing, because these types of commitments might not be considered in computing the debt limitation. Third, some argue that the asset side of the balance sheet is severely understated. For example, companies that use LIFO costing for inventories and depreciate assets on an accelerated basis will often have carrying amounts for inventories and property, plant, and equipment that are much lower than their fair values. As an offset to these lower values, some believe that part of the debt does not have to be reported. In other words, if companies report assets at fair values, less pressure would undoubtedly exist for off-balance-sheet financing arrangements. Whether the arguments above have merit is debatable. The general idea of out of sight, out of mind may not be true in accounting. Many users of financial statements indicate that they factor these off-balance-sheet financing arrangements into their computations when assessing debt to equity relationships. Similarly, many loan covenants also attempt to account for these complex arrangements. Nevertheless, many companies still believe that benefits will accrue if they omit certain obligations from the balance sheet. As a response to off-balance-sheet financing arrangements, the FASB has increased disclosure (note) requirements. This response is consistent with an efficient markets philosophy: the important question is not whether the presentation is off-balance-sheet or not, but whether the items are disclosed at all. In addition, the SEC, in response to the Sarbanes-Oxley Act of 2002, now requires companies to provide related information in their management discussion and analysis sections. Specifically, companies must disclose (1) all contractual obligations in a tabular format and (2) contingent liabilities and commitments in either a textual or tabular format.14 We believe that recording more obligations on the balance sheet will enhance financial reporting. Given the problems with companies such as Enron, Dynegy, Williams Company, Adelphia Communications, and Calpine, and the SarbanesOxley requirements, we expect that less off-balance-sheet financing will occur in the future.
14
It is unlikely that the FASB will be able to stop all types of off-balance-sheet transactions. Financial engineering is the Holy Grail of Wall Street. Developing new financial instruments and arrangements to sell and market to customers is not only profitable, but also adds to the prestige of the investment firms that create them. Thus, new financial products will continue to appear that will test the ability of the FASB to develop appropriate accounting standards for them.
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Presentation and Analysis of Long-Term Debt 711
OBLIGATED
The off-balance-sheet world is slowly but surely becoming more on-balance-sheet. New interpretations on guarantees (discussed in Chapter 13) and variable interest entities (discussed in Appendix 17B) are doing their part to increase the amount of debt reported on corporate balance sheets. In addition, the SEC recently issued a rule that requires companies to disclose off-balancesheet arrangements and contractual obligations that currently have, or are reasonably likely to have, a material future effect on the companies financial condition. Companies now must include a tabular disclosure (following a prescribed format) in the management discussion and analysis section of the annual report. Presented below is Best Buys tabular disclosure of its contractual obligations.
Best Buy Co. Contractual Obligations The following table presents information regarding our contractual obligations by fiscal year ($ in millions): Payments due by period Contractual Obligations Short-term debt obligations Long-term debt obligations Capital lease obligations Financing lease obligations Interest payments Operating lease obligations Purchase obligations Deferred compensation Total Total $ 41 414 24 171 208 6,668 2,198 75 Less than 1 year $ 41 2 3 14 25 741 1,113 13 years $ 0 9 6 30 38 1,387 775 35 years $ 0 403 2 33 33 1,224 291 More than 5 years $ 0 0 13 94 112 3,316 19
What do the numbers mean?
I NTERNATIONAL I NSIGHT There is no comparable institution to the SEC in international securities markets. As a result, many international companies (those not registered with the SEC) are not required to provide disclosures such as those related to contractual obligations.
$9,799
$1,939
$2,245
$1,986
$3,554
Note: For additional information refer to Note 5, Debt; Note 8, Leases; and Note 12, Contingencies and Commitments, in the Notes to Consolidated Financial Statements.
Enrons abuse of off-balance-sheet financing to hide debt was shocking and inappropriate. One silver lining in the Enron debacle however is that the standard-setting bodies in the accounting profession are now providing increased guidance on companies reporting of contractual obligations. We believe the new SEC rule which requires companies to report their obligations over a period of time will be extremely useful to the investment community.
PRESENTATION AND ANALYSIS OF LONG-TERM DEBT
Presentation of Long-Term Debt
Companies that have large amounts and numerous issues of long-term debt freObjective8 quently report only one amount in the balance sheet, supported with comments Indicate how to present and and schedules in the accompanying notes. Long-term debt that matures within analyze long-term debt. one year should be reported as a current liability, unless using noncurrent assets to accomplish retirement. If the company plans to refinance debt, convert it into stock, or retire it from a bond retirement fund, it should continue to report the debt as noncurrent. However, the company should disclose the method it will use in its liquidation. [6], [7] 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. Companies should show any assets pledged as security for the debt in the assets section of the balance sheet. The fair value
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712 Chapter 14 Long-Term Liabilities of the long-term debt should also be disclosed if it is practical to estimate fair value. Finally, companies must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years. These disclosures aid financial statement users in evaluating the amounts and timing of future cash flows. Illustration 14-18 shows an example of the type of information provided for Best Buy Co. Note that if the company has any off-balance-sheet financing, it must provide extensive note disclosure. [8]
ILLUSTRATION 14-18 Long-Term Debt Disclosure
Best Buy Co.
(dollars in millions) Mar. 3, 2007 Total current assets Current liabilities Accounts payable Unredeemed gift card liabilities Accrued compensation and related expenses Accrued liabilities Accrued income taxes Short-term debt Current portion of long-term debt Total current liabilities Long-term liabilities Long-term debt 5. Debt (in part) Convertible subordinated debentures, unsecured, due 2022, interest rate 2.25% Financing lease obligations, due 2009 to 2023, interest rates ranging from 3.0% to 6.5% Capital lease obligations, due 2008 to 2026, interest rates ranging from 1.8% to 8.0% Other debt, due 2010, interest rate 8.8% Total debt Less: Current portion Total long-term debt $9,081 $3,934 496 332 990 489 41 19 6,301 443 590 Mar. 3, 2007 $402 171 24 12 609 (19) $590 Feb. 25, 2006 $7,985 $3,234 469 354 878 703 418 6,056 373 178 Feb. 25, 2006 $402 157 27 10 596 (418) $178
Certain debt is secured by property and equipment with a net book value of $80 and $41 at March 3, 2007, and February 25, 2006, respectively. At March 3, 2007, the future maturities of long-term debt, including capitalized leases, consisted of the following: Fiscal Year 2008 2009 2010 2011 2012 Thereafter $ 19 18 27 18 420 107 $609 The fair value of debt approximated $683 and $693 at March 3, 2007, and February 25, 2006, respectively, based on the ask prices quoted from external sources, compared with carrying values of $650 and $596, respectively.
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Presentation and Analysis of Long-Term Debt 713
Analysis of Long-Term Debt
Long-term creditors and stockholders are interested in a companys long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of the debt at maturity. Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency.
Debt to Total Assets Ratio
The debt to total assets ratio measures the percentage of the total assets provided by creditors. To compute it, divide total debt (both current and long-term liabilities) by total assets, as Illustration 14-19 shows.
Debt to total assets
Total debt Total assets
ILLUSTRATION 14-19 Computation of Debt to Total Assets Ratio
The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.
Times Interest Earned Ratio
The times interest earned ratio indicates the companys ability to meet interest payments as they come due. As shown in Illustration 14-20, it is computed by dividing income before interest expense and income taxes by interest expense.
Times interest earned
Income before income taxes and interest expense Interest expense
ILLUSTRATION 14-20 Computation of Times Interest Earned Ratio
To illustrate these ratios, we use data from Best Buys 2007 annual report. Best Buy has total liabilities of $7,369 million, total assets of $13,570 million, interest expense of $31 million, income taxes of $752 million, and net income of $1,377 million. We compute Best Buys debt to total assets and times interest earned ratios as shown in Illustration 14-21.
Debt to total assets Times interest earned
$7,369 $13,570 ($1,377
54.3% $752 $31 $31) 70 times
ILLUSTRATION 14-21 Computation of Long-Term Debt Ratios for Best Buy
Even though Best Buy has a relatively high debt to total assets percentage of 54.3 percent, its interest coverage of 70 times indicates it can easily meet its interest payments as they come due.
You will want to read the
CONVERGENCE CORNER on page 714 For discussion of how international convergence efforts relate to liabilities.
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CONVERGENCE
CORNER
LIABILITIES
iGAAP and U.S. GAAP have similar definitions for liabilities. iGAAP related to reporting and recognition of liabilities is found in IAS 1 (Presentation of Financial Statements) and IAS 37 (Provisions, Contingent Liabilities, and Contingent Assets).
R E L E VA N T FA C T S
Similar to U.S. practice, iGAAP requires that companies present current and noncurrent liabilities on the face of the balance sheet, with current liabilities generally presented in order of liquidity.
ABOUT THE NUMBERS
As indicated, iGAAP and U.S. GAAP differ as the criteria to be used in recording restructuring liabilities. The following disclosure by Nestl Group in its 2006 annual report reflects application of iGAAP to a restructuring situation.
Under iGAAP, the measurement of a provision related
to a contingency is based on the best estimate of the expenditure required to settle the obligation. If a range of estimates is predicted and no amount in the range is more likely than any other amount in the range, the mid-point of the range is used to measure the liability. In U.S GAAP, the minimum amount in a range is used.
Notes to the Financial Statements 23 provisions (in part) (in millions of CHF) Restructuring At 1 January, 2006 Provisions made in the period Amounts used Unused amounts reversed Modificationtranslation, consolidation At 31 December, 2006 950 437 (326) (34) 7 1,034
Both GAAPs prohibit the recognition of liabilities for
future losses. However, iGAAP permits recognition of a restructuring liability, once a company has committed to a restructuring plan. U.S. GAAP has additional criteria (i.e., related to communicating the plan to employees) before a restructuring liability can be established.
iGAAP and U.S. GAAP are similar in the treatment
of asset retirement obligations (AROs). However, the recognition criteria for an ARO are more stringent under U.S. GAAP: The ARO is not recognized unless there is a present legal obligation and the fair value of the obligation can be reasonably estimated.
Restructuring Restructuring provisions arise from a number of projects across the Group. These include plans to optimise industrial manufacturing capacities by closing inefficient production facilities and reorganising others, mainly in Europe. . . . Restructuring provisions are expected to result in future cash outflows when implementing the plans (usually over the following two to three years) and are consequently not discounted.
iGAAP and U.S. GAAP are similar in their treatment
of contingencies. However, the criteria for recognizing contingent assets are less stringent in the U.S. Under U.S. GAAP, contingent assets for insurance recoveries are recognized if probable; iGAAP requires the recovery be virtually certain before recognition of an asset is permitted.
As indicated in the chapter, the establishment of restructuring liabilities for future costs can be used as a cookie jar to manage net income. That is, companies can set up a liability and related expense charge in one period to reduce income and then reduce the liability in future periods to increase net income. For example, when Nestl makes the following entry for the unused amounts reversed in 2006, it is able to increase its income by 34 million CHF.
Restructuring Liability Gain from Reversal of Restructuring Liability 34 34
We are not implying that Nestl is using its reserve in inappropriate ways. Our point is that less-stringent iGAAP rules for establishing restructuring liabilities could be used as an earnings management tool.
ON TH E HORIZON
As indicated in the Convergence Corner for Chapter 2, the IASB and FASB are working on a conceptual framework project, part of which will examine the definition of a liability. In addition, this project will address the difference in measurements used between iGAAP and U.S. GAAP for contingent liabilities. Also, in its project on business combinations, the IASB is considering changing it definition of a contingent asset to converge with U.S. GAAP.
714
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Summary of Learning Objectives 715
SUMMARY OF LEARNING OBJECTIVES
1 Describe the formal procedures associated with issuing long-term debt. Incurring long-term debt is often a formal procedure. The bylaws of corporations usually require approval by the board of directors and the stockholders before corporations can issue bonds or can make other long-term debt arrangements. Generally, long-term debt has various covenants or restrictions. The covenants and other terms of the agreement between the borrower and the lender are stated in the bond indenture or note agreement. 2 Identify various types of bond issues. Various types of bond issues are: (1) Secured and unsecured bonds. (2) Term, serial, and callable bonds. (3) Convertible, commoditybacked, and deep-discount bonds. (4) Registered and bearer (coupon) bonds. (5) Income and revenue bonds. The variety in the types of bonds results from attempts to attract capital from different investors and risk takers and to satisfy the cash flow needs of the issuers. 3 Describe the accounting valuation for bonds at date of issuance. The investment community values a bond at the present value of its future cash flows, which consist of interest and principal. The rate used to compute the present value of these cash flows is the interest rate that provides an acceptable return on an investment commensurate with the issuers risk characteristics. The interest rate written in the terms of the bond indenture and ordinarily appearing on the bond certificate is the stated, coupon, or nominal rate. The issuer of the bonds sets the rate and expresses it as a percentage of the face value (also called the par value, principal amount, or maturity value) of the bonds. If the rate employed by the buyers differs from the stated rate, the present value of the bonds computed by the buyers will differ from the face value of the bonds. The difference between the face value and the present value of the bonds is either a discount or premium. 4 Apply the methods of bond discount and premium amortization. The discount (premium) is amortized and charged (credited) to interest expense over the life of the bonds. Amortization of a discount increases bond interest expense, and amortization of a premium decreases bond interest expense. The professions preferred procedure for amortization of a discount or premium is the effective-interest method. Under the effective-interest method, (1) bond interest expense is computed by multiplying the carrying value of the bonds at the beginning of the period by the effective-interest rate; then, (2) the bond discount or premium amortization is determined by comparing the bond interest expense with the interest to be paid. 5 Describe the accounting for the extinguishment of debt. At the time of reacquisition of long-term debt, the unamortized premium or discount and any costs of issue applicable to the debt must be amortized up to the reacquisition date. The reacquisition price is the amount paid on extinguishment or redemption before maturity, including any call premium and expense of reacquisition. On any specified date, the net carrying amount of the debt is the amount payable at maturity, adjusted for unamortized premium or discount and issue costs. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the net carrying amount is a loss from extinguishment. Gains and losses on extinguishments are recognized currently in income. 6 Explain the accounting for long-term notes payable. Accounting procedures for notes and bonds are similar. Like a bond, a note is valued at the present value of its expected future interest and principal cash flows, with any discount or premium being similarly amortized over the life of the note. Whenever the face amount of the note does not reasonably represent the present value of the consideration in the exchange,
KEY TERMS
bearer (coupon) bonds, 691 bond discount, 693 bond indenture, 690 bond premium, 693 callable bonds, 691 carrying value, 697 commodity-backed bonds, 691 convertible bonds, 691 debenture bonds, 691 debt to total assets ratio, 713 deep-discount (zerointerest debenture) bonds, 691 effective-interest method, 697 effective yield, or market rate, 693 extinguishment of debt, 701 face, par, principal or maturity value, 692 imputation, 707 imputed interest rate, 707 income bonds, 691 long-term debt, 690 long-term notes payable, 703 mortgage notes payable, 708 off-balance-sheet financing, 709 refunding, 702 registered bonds, 691 revenue bonds, 691 secured bonds, 691 serial bonds, 691 special purpose entity (SPE), 709 stated, coupon, or nominal rate, 692 straight-line method, 695 term 691 bonds, times interest earned ratio, 713 zero-interest debenture bonds, 691
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716 Chapter 14 Long-Term Liabilities a company must evaluate the entire arrangement in order to properly record the exchange and the subsequent interest.
7 Explain the reporting of off-balance-sheet financing arrangements. Off-balance-sheet financing is an attempt to borrow funds in such a way to prevent recording obligations. Examples of off-balance-sheet arrangements are (1) non-consolidated subsidiaries, (2) special purpose entities, and (3) operating leases. 8 Indicate how to present and analyze long-term debt. Companies that have large amounts and numerous issues of long-term debt frequently report only one amount in the balance sheet and support this with comments and schedules in the accompanying notes. Any assets pledged as security for the debt should be shown in the assets section of the balance sheet. Long-term debt that matures within one year should be reported as a current liability, unless retirement is to be accomplished with other than current assets. If a company plans to refinance the debt, convert it into stock, or retire it from a bond retirement fund, it should continue to report it as noncurrent, accompanied with a note explaining the method it will use in the debts liquidation. Disclosure is required of future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years. Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency.
APPENDIX
14A
TROUBLED-DEBT RESTRUCTURINGS
Practically every day, the Wall Street Journal runs a story about some company in financial difficulty. Notable recent examples are Delphi, Northwest Airlines, and United Airlines. In most troubled-debt situations, the creditor usually first recognizes a loss on impairment. Subsequently, the creditor either modifies the terms of the loan or the debtor settles the loan on terms unfavorable to the creditor. In unusual cases, the creditor forces the debtor into bankruptcy in order to ensure the highest possible collection on the loan. Illustration 14A-1 shows this continuum.
ILLUSTRATION 14A-1 Usual Progression in Troubled-Debt Situations
Loan Origination Loan Impairment Modification of Terms Bankruptcy
To illustrate, consider the case of Huffy Corp., a name that adorned the first bicycle of many American children. Before its bankruptcy, Huffys creditors likely recognized a loss on impairment. Subsequently, the creditors either modified the terms of the loan or settled it on terms unfavorable to the creditor. Finally, the creditors forced Huffy into bankruptcy, and the suppliers received a 30 percent equity stake in Huffy. These terms helped ensure the highest possible collection on the Huffy loan.
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Appendix: Troubled-Debt Restructurings 717 We discussed the accounting for loan impairments in Appendix 7B. The purObjective9 pose of this appendix is to explain how creditors and debtors report information Describe the accounting for a debt in financial statements related to troubled-debt restructurings. restructuring. A troubled-debt restructuring occurs when a creditor for economic or legal reasons related to the debtors financial difficulties grants a concession to the debtor that it would not otherwise consider. [9] Thus a troubled-debt restructuring does not apply to modifications of a debt obligation that reflect general economic conditions leading to a reduced interest rate. Nor does it apply to the refunding of an old debt with new debt having an effective interest rate approximately equal to that of similar debt issued by nontroubled debtors. A troubled-debt restructuring involves one of two basic types of transactions:
1. Settlement of debt at less than its carrying amount. 2. Continuation of debt with a modification of terms.
SETTLEMENT OF DEBT
In addition to using cash, settling a debt obligation can involve either a transfer of noncash assets (real estate, receivables, or other assets) or the issuance of the debtors stock. In these situations, the creditor should account for the noncash assets or equity interest received at their fair value. The debtor must determine the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain). Likewise, the creditor must determine the excess of the receivable over the fair value of those same assets or equity interests transferred (loss). The debtor recognizes a gain equal to the amount of the excess. The creditor normally charges the excess (loss) against Allowance for Doubtful Accounts. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair value of those assets differs from their carrying amount (book value).
Transfer of Assets
Assume that American City Bank loaned $20,000,000 to Union Mortgage Company. Union Mortgage, in turn, invested these monies in residential apartment buildings. However, because of low occupancy rates, it cannot meet its loan obligations. American City Bank agrees to accept from Union Mortgage real estate with a fair value of $16,000,000 in full settlement of the $20,000,000 loan obligation. The real estate has a carrying value of $21,000,000 on the books of Union Mortgage. American City Bank (creditor) records this transaction as follows.
Real Estate Allowance for Doubtful Accounts Note Receivable from Union Mortgage 16,000,000 4,000,000 20,000,000
The bank records the real estate at fair value. Further, it makes a charge to the Allowance for Doubtful Accounts to reflect the bad debt write-off. Union Mortgage (debtor) records this transaction as follows.
Note Payable to American City Bank Loss on Disposition of Real Estate Real Estate Gain on Restructuring of Debt 20,000,000 5,000,000 21,000,000 4,000,000
Union Mortgage has a loss on the disposition of real estate in the amount of $5,000,000 (the difference between the $21,000,000 book value and the $16,000,000 fair value). It should show this as an ordinary loss on the income statement. In addition, it has a gain on restructuring of debt of $4,000,000 (the difference between the $20,000,000 carrying amount of the note payable and the $16,000,000 fair value of the real estate).
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718 Chapter 14 Long-Term Liabilities
Granting of Equity Interest
Assume that American City Bank agrees to accept from Union Mortgage 320,000 shares of common stock ($10 par) that has a fair value of $16,000,000, in full settlement of the $20,000,000 loan obligation. American City Bank (creditor) records this transaction as follows.
Investment Allowance for Doubtful Accounts Note Receivable from Union Mortgage 16,000,000 4,000,000 20,000,000
It records the stock as an investment at the fair value at the date of restructure. Union Mortgage (debtor) records this transaction as follows.
Note Payable to American City Bank Common Stock Additional Paid-in Capital Gain on Restructuring of Debt 20,000,000 3,200,000 12,800,000 4,000,000
It records the stock issued in the normal manner. It records the difference between the par value and the fair value of the stock as additional paid-in capital.
MODIFICATION OF TERMS
In some cases, a debtors serious short-run cash flow problems will lead it to request one or a combination of the following modifications:
1. 2. 3. 4.
Reduction of the stated interest rate. Extension of the maturity date of the face amount of the debt. Reduction of the face amount of the debt. Reduction or deferral of any accrued interest.
The creditors loss is based on expected cash flows discounted at the historical effective rate of the loan. [10] The debtor calculates its gain based on undiscounted amounts. As a consequence, the gain recorded by the debtor will not equal the loss recorded by the creditor under many circumstances.15 Two examples demonstrate the accounting for a troubled-debt restructuring by debtors and creditors:
1. The debtor does not record a gain. 2. The debtor does record a gain.
In both instances the creditor has a loss.
Example 1No Gain for Debtor
This example demonstrates a restructuring in which the debtor records no gain.16 On December 31, 2009, Morgan National Bank enters into a debt restructuring agreement
15
In response to concerns expressed about this nonsymmetric treatment, the FASB stated that it did not address debtor accounting because expansion of the scope of the statement would delay its issuance. By basing the debtor calculation on undiscounted amounts, the amount of gain (if any) recognized by the debtor is reduced at the time the modification of terms occurs. If fair value were used, the gain recognized would be greater. The result of this approach is to spread the unrecognized gain over the life of the new agreement. We believe that this accounting is inappropriate and hopefully will change as more fair value measurements are introduced into the financial statements. Note that the examples given for restructuring assume the creditor made no previous entries for impairment. In actuality it is likely that the creditor would have already made an entry when the loan initially became impaired. Restructuring would, therefore, simply require an adjustment of the initial estimated bad debt by the creditor. Recall, however, that the debtor makes no entry upon impairment.
16
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Appendix: Troubled-Debt Restructurings 719 with Resorts Development Company, which is experiencing financial difficulties. The bank restructures a $10,500,000 loan receivable issued at par (interest paid to date) by:
1. Reducing the principal obligation from $10,500,000 to $9,000,000; 2. Extending the maturity date from December 31, 2009, to December 31, 2013; and 3. Reducing the interest rate from 12% to 8%.
Debtor Calculations
The total future cash flow, after restructuring of $11,880,000 ($9,000,000 of principal plus $2,880,000 of interest payments17), exceeds the total pre-restructuring carrying amount of the debt of $10,500,000. Consequently, the debtor records no gain nor makes any adjustment to the carrying amount of the payable. As a result, Resorts Development (debtor) makes no entry at the date of restructuring. The debtor must compute a new effective interest rate in order to record interest expense in future periods. The new effective interest rate equates the present value of the future cash flows specified by the new terms with the pre-restructuring carrying amount of the debt. In this case, Resorts Development computes the new rate by relating the pre-restructure carrying amount ($10,500,000) to the total future cash flow ($11,880,000). The rate necessary to discount the total future cash flow ($11,880,000), to a present value equal to the remaining balance ($10,500,000), is 3.46613%.18 On the basis of the effective rate of 3.46613%, the debtor prepares the schedule shown in Illustration 14A-2.
ILLUSTRATION 14A-2 Schedule Showing Reduction of Carrying Amount of Note
Calculator Solution for Interest Rate Inputs Answer
RESORTS DEVELOPMENT CO. (DEBTOR) Cash Paid (8%) $ 720,000a 720,000 720,000 720,000 $2,880,000
a
Date 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13
Interest Expense (3.46613%) $ 363,944b 351,602 338,833 325,621 $1,380,000
Reduction of Carrying Amount $ 356,056c 368,398 381,167 394,379 $1,500,000
Carrying Amount of Note $10,500,000 10,143,944 9,775,546 9,394,379 9,000,000
N I/YR PV
4
$720,000 $363,944 c $356,056
b
$9,000,000 .08 $10,500,000 3.46613% $720,000 $363,944
?
3.466
10,500,000
Thus, on December 31, 2010 (date of first interest payment after restructure), the debtor makes the following entry.
December 31, 2010 Notes Payable Interest Expense Cash 356,056 363,944 720,000
PMT FV
720,000
9,000,000
17 18
Total interest payments are: $9,000,000
.08
4 years
$2,880,000.
An accurate interest rate i can be found by using the formulas given at the tops of Tables 6-2 and 6-4 to set up the following equation. 1 (1 i)
4
1 $9,000,000
1 (1 i i)4 $720,000
$10,500,000
(from Table 6-2) Solving algebraically for i, we find that i
(from Table 6-4) 3.46613%.
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720 Chapter 14 Long-Term Liabilities The debtor makes a similar entry (except for different amounts for debits to Notes Payable and Interest Expense) each year until maturity. At maturity, Resorts Development makes the following entry.
December 31, 2013 Notes Payable Cash 9,000,000 9,000,000
Creditor Calculations
Morgan National Bank (creditor) must calculate its loss based on the expected future cash flows discounted at the historical effective rate of the loan. It calculates this loss as shown in Illustration 14A-3.
ILLUSTRATION 14A-3 Computation of Loss to Creditor on Restructuring
Pre-restructure carrying amount Present value of restructured cash flows: Present value of $9,000,000 due in 4 years at 12%, interest payable annually (Table 6-2); FV(PVF4,12%); ($9,000,000 .63552) Present value of $720,000 interest payable annually for 4 years at 12% (Table 6-4); R(PVF-OA4,12%); ($720,000 3.03735) Present value of restructured cash flows Loss on restructuring
$10,500,000
$5,719,680
2,186,892 7,906,572 $ 2,593,428
As a result, Morgan National Bank records bad debt expense as follows (assuming no establishment of an allowance balance from recognition of an impairment).
Bad Debt Expense Allowance for Doubtful Accounts 2,593,428 2,593,428
In subsequent periods, Morgan National Bank reports interest revenue based on the historical effective rate. Illustration 14A-4 provides the following interest and amortization information.
ILLUSTRATION 14A-4 Schedule of Interest and Amortization after Debt Restructuring
MORGAN NATIONAL BANK (CREDITOR) Cash Received (8%) $ 720,000a 720,000 720,000 720,000 $2,880,000 Interest Revenue (12%) $ 948,789b 976,243 1,006,992 1,041,404d $3,973,428 Increase of Carrying Amount $ 228,789c 256,243 286,992 321,404d $1,093,428 Carrying Amount of Note $7,906,572 8,135,361 8,391,604 8,678,596 9,000,000
Date 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13 Total
a
$720,000 $9,000,000 .08 $948,789 $7,906,572 .12 c $228,789 $948,789 $720,000 d $28 adjustment to compensate for rounding.
b
On December 31, 2010, Morgan National Bank makes the following entry.
December 31, 2010 Cash Allowance for Doubtful Accounts Interest Revenue 720,000 228,789 948,789
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Appendix: Troubled-Debt Restructurings 721 The creditor makes a similar entry (except for different amounts debited to Allowance for Doubtful Accounts and credited to Interest Revenue) each year until maturity. At maturity, the company makes the following entry.
December 31, 2013 Cash Allowance for Doubtful Accounts Notes Receivable 9,000,000 1,500,000 10,500,000
Example 2Gain for Debtor
If the pre-restructure carrying amount exceeds the total future cash flows as a result of a modification of the terms, the debtor records a gain. To illustrate, assume the facts in the previous example except that Morgan National Bank reduces the principal to $7,000,000 (and extends the maturity date to December 31, 2013, and reduces the interest from 12% to 8%). The total future cash flow is now $9,240,000 ($7,000,000 of principal plus $2,240,000 of interest19), which is $1,260,000 ($10,500,000 $9,240,000) less than the pre-restructure carrying amount of $10,500,000. Under these circumstances, Resorts Development (debtor) reduces the carrying amount of its payable $1,260,000 and records a gain of $1,260,000. On the other hand, Morgan National Bank (creditor) debits its Bad Debt Expense for $4,350,444. Illustration 14A-5 shows this computation.
ILLUSTRATION 14A-5 Computation of Loss to Creditor on Restructuring
Pre-restructure carrying amount Present value of restructured cash flows: Present value of $7,000,000 due in 4 years at 12%, interest payable annually (Table 6-2); FV(PVF4,12%); ($7,000,000 .63552) Present value of $560,000 interest payable annually for 4 years at 12% (Table 6-4); R(PVF-OA4,12%); ($560,000 3.03735) Creditors loss on restructuring
$10,500,000
$4,448,640
1,700,916
6,149,556 $ 4,350,444
Illustration 14A-6 shows the entries to record the gain and loss on the debtors and creditors books at the date of restructure, December 31, 2009.
Resorts Development Co. (Debtor) Notes Payable Gain on Restructuring of Debt 1,260,000
December 31, 2009 (date of restructure) Morgan National Bank (Creditor) Bad Debt Expense Allowance for Doubtful Accounts 1,260,000 4,350,444 4,350,444
For Resorts Development (debtor), because the new carrying value of the note ($10,500,000 $1,260,000 $9,240,000) equals the sum of the undiscounted cash flows ($9,240,000), the imputed interest rate is 0 percent. Consequently, all of the future cash flows reduce the principal balance, and the company recognizes no interest expense. Morgan National reports the interest revenue in the same fashion as the previous examplethat is, using the historical effective interest rate applied toward the newly discounted value of the note. Illustration 14A-7 (on page 722) shows interest computations.
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ILLUSTRATION 14A-6 Debtor and Creditor Entries to Record Gain and Loss on Note
Total interest payments are: $7,000,000
.08
4 years
$2,240,000.
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722 Chapter 14 Long-Term Liabilities
ILLUSTRATION 14A-7 Schedule of Interest and Amortization after Debt Restructuring
MORGAN NATIONAL BANK (CREDITOR) Cash Received (8%) $ 560,000a 560,000 560,000 560,000 $2,240,000 Interest Revenue (12%) $ 737,947b 759,300 783,216 809,981d $3,090,444 Increase in Carrying Amount $177,947c 199,300 223,216 249,981d $850,444 Carrying Amount of Note $6,149,556 6,327,503 6,526,803 6,750,019 7,000,000
Date 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13 Total
a
$560,000 $7,000,000 .08 $737,947 $6,149,556 .12 $177,947 $737,947 $560,000 d $21 adjustment to compensate for rounding.
b c
The journal entries in Illustration 14A-8 demonstrate the accounting by debtor and creditor for periodic interest payments and final principal payment.
Resorts Development Co. (Debtor) Notes Payable Cash 560,000 560,000 Morgan National Bank (Creditor) Cash Allowance for Doubtful Accounts Interest Revenue 560,000 177,947 737,947
December 31, 2010 (date of first interest payment following restructure)
December 31, 2011, 2012, and 2013 (dates of 2nd, 3rd, and last interest payments) (Debit and credit same accounts as 12/31/10 using applicable amounts from appropriate amortization schedules.) December 31, 2013 (date of principal payment) Notes Payable Cash 7,000,000 7,000,000 Cash Allowance for Doubtful Accounts Notes Receivable 7,000,000 3,500,000 10,500,000
ILLUSTRATION 14A-8 Debtor and Creditor Entries to Record Periodic Interest and Final Principal Payments
CONCLUDING REMARKS
The accounting for troubled debt is complex because the accounting standards allow for use of different measurement standards to determine the loss or gain reported. In addition, the assets and liabilities reported are sometimes not stated at cost or fair value, but at amounts adjusted for certain events but not others. This cumbersome accounting demonstrates the need for adoption of a comprehensive fair-value model for financial instruments that is consistent with finance concepts for pricing these financial instruments.
KEY TERM
troubled-debt restructuring, 717
SUMMARY OF LEARNING OBJECTIVE
9 Describe the accounting for a debt restructuring. There are two types of debt settlements: (1) transfer of noncash assets, and (2) granting of equity interest. Creditors and debtors record losses and gains on settlements based on fair values. For accounting purposes there are also two types of restructurings with continuation of debt with modified terms: (1) the carrying amount of debt is less than the future cash flows, and (2) the carrying amount of debt exceeds the total future cash flows. Creditors record losses on these restructurings based on the expected future cash flows discounted at the historical effective interest rate. The debtor determines its gain based on undiscounted cash flows.
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FASB Codification 723
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 835-30-55-2. [Predecessor literature: Interest on Receivables and Payables, Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 16.] [2] FASB ASC 835-30-35-2. [Predecessor literature: Interest on Receivables and Payables, Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 15.] [3] FASB ASC 470-50-45. [Predecessor literature: Rescission of FASB Statements No. 4, 44, and 64 and Technical Corrections, Statement of Accounting Standards No. 145 (Norwalk, Conn.: FASB, 2002).] [4] FASB ASC 835-30-15-3. [Predecessor literature: Interest on Receivables and Payables, Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971).] [5] FASB ASC 835-30-05-2. [Predecessor literature: Interest on Receivables and Payables, Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 12.] [6] FASB ASC 470-10-50-4. [Predecessor literature: Balance Sheet Classification of Short-Term Obligations Expected to Be Refinanced, FASB Statement of Financial Accounting Standards No. 6 (Stamford, Conn.: FASB, 1975), par. 15.] [7] FASB ASC 505-10-50-3. [Predecessor literature: Disclosure of Information about Capital Structure, FASB Statement of Financial Accounting Standards No. 129 (Norwalk, Conn.: 1997), par. 4.] [8] FASB ASC 470-10-50-1. [Predecessor literature: Disclosure of Long-Term Obligations, FASB Statement of Financial Accounting Standards No. 47 (Stamford, Conn.: 1981), par. 10.] [9] FASB ASC 310-40-15-2. [Predecessor literature: Accounting by Debtors and Creditors for Troubled Debt Restructurings, FASB Statement No. 15 (Norwalk, Conn.: FASB, June, 1977), par. 1.] [10] FASB ASC 310-10-35. [Predecessor literature: Accounting by Creditors for Impairment of a Loan, FASB Statement No. 114, (Norwalk, Conn.: FASB, May 1993), par. 42.]
Exercises
Access the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. Provide Codification references for your responses. CE14-1 Access the glossary (Master Glossary) to answer the following. (a) (b) (c) (d) What What What What does the term callable obligation mean? is an imputed interest rate? is a long-term obligation? is the definition of effective interest rate?
CE14-2 What guidance does the Codification provide on the disclosure of long-term obligations? CE14-3 Describe how a company would classify debt that includes covenants. What conditions must exist in order to depart from the normal rule? CE14-4 A company proposes to include in its SEC registration statement a balance sheet showing its subordinate debt as a portion of stockholders equity. Will the SEC allow this? Why or why not? An additional Codification case can be found in the Using Your Judgment section, on page 739.
Be sure to check the companion website for a Review and Analysis Exercise, with solution.
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724 Chapter 14 Long-Term Liabilities Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
QUESTIONS
1. (a) From what sources might a corporation obtain funds
through long-term debt? (b) What is a bond indenture? What does it contain? (c) What is a mortgage?
14. What is done to record properly a transaction involving
the issuance of a non-interest-bearing long-term note in exchange for property?
2. Potlatch Corporation has issued various types of bonds
such as term bonds, income bonds, and debentures. Differentiate between term bonds, mortgage bonds, collateral trust bonds, debenture bonds, income bonds, callable bonds, registered bonds, bearer or coupon bonds, convertible bonds, commodity-backed bonds, and deep discount bonds.
15. How is the present value of a non-interest-bearing note
computed?
16. When is the stated interest rate of a debt instrument presumed to be fair?
17. What are the considerations in imputing an appropriate
interest rate?
3. Distinguish between the following interest rates for bonds
payable: (a) yield rate (b) nominal rate (c) stated rate (d) market rate (e) effective rate
18. Differentiate between a fixed-rate mortgage and a
variable-rate mortgage.
19. What disclosures are required relative to long-term debt
and sinking fund requirements?
20. What is off-balance-sheet financing? Why might a company be interested in using off-balance-sheet financing?
4. Distinguish between the following values relative to
bonds payable: (a) maturity value (b) face value (c) market value (d) par value
21. What are some forms of off-balance-sheet financing? 22. Explain how a non-consolidated subsidiary can be a form
of off-balance-sheet financing.
5. Under what conditions of bond issuance does a discount
on bonds payable arise? Under what conditions of bond issuance does a premium on bonds payable arise?
23. Where can authoritative iGAAP guidance related to liabilities be found?
6. How should discount on bonds payable be reported on
the financial statements? Premium on bonds payable?
24. Briefly describe some of the similarities and differences
between U.S. GAAP and iGAAP with respect to the accounting for liabilities.
7. What are the two methods of amortizing discount and premium on bonds payable? Explain each.
25. Hong Kong Trading Co. (which uses iGAAP) is in the
midst of a multi-year operational restructuring. It reported the following information in its 2010 annual report (amounts in $, in millions): Restructuring provision balance at 1 January 2010, $135; provisions made in the period, $275; and unused amounts reversed, $22. Respond to the following: (a) What is the balance for the Restructuring Provision at 31 December 2010? (b) How did the reversal of unused amounts affect net income? (c) Briefly discuss how the accounting for the restructuring provision can be used for earnings management.
8. Zopf Company sells its bonds at a premium and applies
the effective-interest method in amortizing the premium. Will the annual interest expense increase or decrease over the life of the bonds? Explain.
9. Briggs and Stratton recently reported unamortized debt
issue costs of $5.1 million. How should the costs of issuing these bonds be accounted for and classified in the financial statements?
10. Will the amortization of Discount on Bonds Payable increase or decrease Bond Interest Expense? Explain.
26. Briefly discuss how accounting convergence efforts addressing liabilities are related to the IASB/FASB conceptual framework project.
11. What is the call feature of a bond issue? How does the
call feature affect the amortization of bond premium or *27. What are the types of situations that result in troubled debt? discount? 12. Why would a company wish to reduce its bond indebt- *28. What are the general rules for measuring gain or loss by both creditor and debtor in a troubled-debt restructuring edness before its bonds reach maturity? Indicate how this involving a settlement? can be done and the correct accounting treatment for such a transaction.
*29. (a) In a troubled-debt situation, why might the creditor
grant concessions to the debtor? (b) What type of concessions might a creditor grant the debtor in a troubled-debt situation?
13. How are gains and losses from extinguishment of a debt
classified in the income statement? What disclosures are required of such transactions?
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Brief Exercises 725 *30. What are the general rules for measuring and recognizing gain or loss by both the debtor and the creditor in a troubled-debt restructuring involving a modification of terms? *32. *31. What is meant by accounting symmetry between the entries recorded by the debtor and creditor in a troubleddebt restructuring involving a modification of terms? In what ways is the accounting for troubled-debt restructurings non-symmetrical? Under what circumstances would a transaction be recorded as a troubled-debt restructuring by only one of the two parties to the transaction?
BRIEF EXERCISES
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BE14-1 Whiteside Corporation issues $500,000 of 9% bonds, due in 10 years, with interest payable semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds. BE14-2 The Colson Company issued $300,000 of 10% bonds on January 1, 2011. The bonds are due January 1, 2016, with interest payable each July 1 and January 1. The bonds are issued at face value. Prepare Colsons journal entries for (a) the January issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry. BE14-3 Assume the bonds in BE14-2 were issued at 98. Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31. Assume The Colson Company records straight-line amortization semiannually. BE14-4 Assume the bonds in BE14-2 were issued at 103. Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31. Assume The Colson Company records straight-line amortization semiannually. BE14-5 Devers Corporation issued $400,000 of 6% bonds on May 1, 2011. The bonds were dated January 1, 2011, and mature January 1, 2013, with interest payable July 1 and January 1. The bonds were issued at face value plus accrued interest. Prepare Deverss journal entries for (a) the May 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry. BE14-6 On January 1, 2011, JWS Corporation issued $600,000 of 7% bonds, due in 10 years. The bonds were issued for $559,224, and pay interest each July 1 and January 1. JWS uses the effective-interest method. Prepare the companys journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry. Assume an effective interest rate of 8%. BE14-7 Assume the bonds in BE14-6 were issued for $644,636 and the effective interest rate is 6%. Prepare the companys journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry. BE14-8 Teton Corporation issued $600,000 of 7% bonds on November 1, 2011, for $644,636. The bonds were dated November 1, 2011, and mature in 10 years, with interest payable each May 1 and November 1. Teton uses the effective-interest method with an effective rate of 6%. Prepare Tetons December 31, 2011, adjusting entry. BE14-9 At December 31, 2011, Hyasaki Corporation has the following account balances:
Bonds payable, due January 1, 2019 Discount on bonds payable Bond interest payable $2,000,000 88,000 80,000
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Show how the above accounts should be presented on the December 31, 2011, balance sheet, including the proper classifications.
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BE14-10 Wasserman Corporation issued 10-year bonds on January 1, 2011. Costs associated with the bond issuance were $160,000. Wasserman uses the straight-line method to amortize bond issue costs. Prepare the December 31, 2011, entry to record 2011 bond issue cost amortization. BE14-11 On January 1, 2011, Henderson Corporation retired $500,000 of bonds at 99. At the time of retirement, the unamortized premium was $15,000 and unamortized bond issue costs were $5,250. Prepare the corporations journal entry to record the reacquisition of the bonds. BE14-12 Coldwell, Inc. issued a $100,000, 4-year, 10% note at face value to Flint Hills Bank on January 1, 2011, and received $100,000 cash. The note requires annual interest payments each December 31. Prepare Coldwells journal entries to record (a) the issuance of the note and (b) the December 31 interest payment.
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726 Chapter 14 Long-Term Liabilities
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BE14-13 Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company on January 1, 2011, and received cash of $47,664. The implicit interest rate is 12%. Prepare Samsons journal entries for (a) the January 1 issuance and (b) the December 31 recognition of interest. BE14-14 McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on January 1, 2011, and received a computer that normally sells for $31,495. The note requires annual interest payments each December 31. The market rate of interest for a note of similar risk is 12%. Prepare McCormicks journal entries for (a) the January 1 issuance and (b) the December 31 interest. BE14-15 Shlee Corporation issued a 4-year, $60,000, zero-interest-bearing note to Garcia Company on January 1, 2011, and received cash of $60,000. In addition, Shlee agreed to sell merchandise to Garcia at an amount less than regular selling price over the 4-year period. The market rate of interest for similar notes is 12%. Prepare Shlee Corporations January 1 journal entry.
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EXERCISES
2
E14-1 (Classification of Liabilities)
Presented below are various account balances.
(a) Bank loans payable of a winery, due March 10, 2014. (The product requires aging for 5 years before sale.) (b) Unamortized premium on bonds payable, of which $3,000 will be amortized during the next year. (c) Serial bonds payable, $1,000,000, of which $250,000 are due each July 31. (d) Amounts withheld from employees wages for income taxes. (e) Notes payable due January 15, 2013. (f) Credit balances in customers accounts arising from returns and allowances after collection in full of account. (g) Bonds payable of $2,000,000 maturing June 30, 2012. (h) Overdraft of $1,000 in a bank account. (No other balances are carried at this bank.) (i) Deposits made by customers who have ordered goods. Instructions Indicate whether each of the items above should be classified on December 31, 2011, as a current liability, a long-term liability, or under some other classification. Consider each one independently from all others; that is, do not assume that all of them relate to one particular business. If the classification of some of the items is doubtful, explain why in each case.
2
E14-2 (Classification) (a) (b) (c) (d) (e) (f) (g) (h) (i)
The following items are found in the financial statements.
Discount on bonds payable Interest expense (credit balance) Unamortized bond issue costs Gain on repurchase of debt Mortgage payable (payable in equal amounts over next 3 years) Debenture bonds payable (maturing in 5 years) Premium on bonds payable Notes payable (due in 4 years) Income bonds payable (due in 3 years)
Instructions Indicate how each of these items should be classified in the financial statements.
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E14-3 (Entries for Bond Transactions) Presented below are two independent situations. 1. 2. On January 1, 2010, Divac Company issued $300,000 of 9%, 10-year bonds at par. Interest is payable quarterly on April 1, July 1, October 1, and January 1. On June 1, 2010, Verbitsky Company issued $200,000 of 12%, 10-year bonds dated January 1 at par plus accrued interest. Interest is payable semiannually on July 1 and January 1.
Instructions For each of these two independent situations, prepare journal entries to record the following. (a) The issuance of the bonds. (b) The payment of interest on July 1. (c) The accrual of interest on December 31.
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Exercises 727
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E14-4 (Entries for Bond TransactionsStraight-Line) Foreman Company issued $800,000 of 10%, 20-year bonds on January 1, 2011, at 102. Interest is payable semiannually on July 1 and January 1. Foreman Company uses the straight-line method of amortization for bond premium or discount. Instructions Prepare the journal entries to record the following. (a) The issuance of the bonds. (b) The payment of interest and the related amortization on July 1, 2011. (c) The accrual of interest and the related amortization on December 31, 2011.
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E14-5 (Entries for Bond TransactionsEffective-Interest) Assume the same information as in E14-4, except that Foreman Company uses the effective-interest method of amortization for bond premium or discount. Assume an effective yield of 9.7705%. Instructions Prepare the journal entries to record the following. (Round to the nearest dollar.) (a) The issuance of the bonds. (b) The payment of interest and related amortization on July 1, 2011. (c) The accrual of interest and the related amortization on December 31, 2011.
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E14-6 (Amortization SchedulesStraight-Line) Spencer Company sells 10% bonds having a maturity value of $3,000,000 for $2,783,724. The bonds are dated January 1, 2010, and mature January 1, 2015. Interest is payable annually on January 1. Instructions Set up a schedule of interest expense and discount amortization under the straight-line method.
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E14-7 (Amortization ScheduleEffective-Interest) Assume the same information as E14-6. Instructions Set up a schedule of interest expense and discount amortization under the effective-interest method. (Hint: The effective interest rate must be computed.)
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E14-8 (Determine Proper Amounts in Account Balances) Presented below are three independent situations. (a) Chinook Corporation incurred the following costs in connection with the issuance of bonds: (1) printing and engraving costs, $15,000; (2) legal fees, $49,000, and (3) commissions paid to underwriter, $60,000. What amount should be reported as Unamortized Bond Issue Costs, and where should this amount be reported on the balance sheet? (b) McEntire Co. sold $2,500,000 of 10%, 10-year bonds at 104 on January 1, 2010. The bonds were dated January 1, 2010, and pay interest on July 1 and January 1. If McEntire uses the straight-line method to amortize bond premium or discount, determine the amount of interest expense to be reported on July 1, 2010, and December 31, 2010. (c) Cheriel Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2010, for $562,500. This price provided a yield of 10% on the bonds. Interest is payable semiannually on December 31 and June 30. If Cheriel uses the effective-interest method, determine the amount of interest expense to record if financial statements are issued on October 31, 2010.
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E14-9 (Entries and Questions for Bond Transactions) On June 30, 2010, Mackes Company issued $5,000,000 face value of 13%, 20-year bonds at $5,376,150, a yield of 12%. Mackes uses the effective-interest method to amortize bond premium or discount. The bonds pay semiannual interest on June 30 and December 31. Instructions (a) Prepare the journal entries to record the following transactions. (1) The issuance of the bonds on June 30, 2010. (2) The payment of interest and the amortization of the premium on December 31, 2010. (3) The payment of interest and the amortization of the premium on June 30, 2011. (4) The payment of interest and the amortization of the premium on December 31, 2011. (b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2011, balance sheet.
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728 Chapter 14 Long-Term Liabilities
(c) Provide the answers to the following questions. (1) What amount of interest expense is reported for 2011? (2) Will the bond interest expense reported in 2011 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used? (3) Determine the total cost of borrowing over the life of the bond. (4) Will the total bond interest expense for the life of the bond be greater than, the same as, or less than the total interest expense if the straight-line method of amortization were used?
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E14-10 (Entries for Bond Transactions) On January 1, 2010, Osborn Company sold 12% bonds having a maturity value of $800,000 for $860,651.79, which provides the bondholders with a 10% yield. The bonds are dated January 1, 2010, and mature January 1, 2015, with interest payable December 31 of each year. Osborn Company allocates interest and unamortized discount or premium on the effective interest basis. Instructions (a) Prepare (b) Prepare (c) Prepare (d) Prepare the journal entry at the date of the bond issuance. a schedule of interest expense and bond amortization for 20102012. the journal entry to record the interest payment and the amortization for 2010. the journal entry to record the interest payment and the amortization for 2012. Pawnee Inc. has issued three types of debt on
3
E14-11 (Information Related to Various Bond Issues) January 1, 2010, the start of the companys fiscal year.
(a) $10 million, 10-year, 13% unsecured bonds, interest payable quarterly. Bonds were priced to yield 12%. (b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year. (c) $15 million, 10-year, 10% mortgage bonds, interest payable annually to yield 12%. Instructions Prepare a schedule that identifies the following items for each bond: (1) maturity value, (2) number of interest periods over life of bond, (3) stated rate per each interest period, (4) effective interest rate per each interest period, (5) payment amount per period, and (6) present value of bonds at date of issue.
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E14-12 (Entry for Retirement of Bond; Bond Issue Costs) On January 2, 2005, Prebish Corporation issued $1,500,000 of 10% bonds at 97 due December 31, 2014. Legal and other costs of $24,000 were incurred in connection with the issue. Interest on the bonds is payable annually each December 31. The $24,000 issue costs are being deferred and amortized on a straight-line basis over the 10-year term of the bonds. The discount on the bonds is also being amortized on a straight-line basis over the 10 years. (Straight-line is not materially different in effect from the preferable interest method.) The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 2010, Prebish called $1,000,000 face amount of the bonds and retired them. Instructions Ignoring income taxes, compute the amount of loss, if any, to be recognized by Prebish as a result of retiring the $1,000,000 of bonds in 2010 and prepare the journal entry to record the retirement. (AICPA adapted)
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E14-13 (Entries for Retirement and Issuance of Bonds) Robinson, Inc. had outstanding $5,000,000 of 11% bonds (interest payable July 31 and January 31) due in 10 years. On July 1, it issued $7,000,000 of 10%, 15-year bonds (interest payable July 1 and January 1) at 98. A portion of the proceeds was used to call the 11% bonds at 102 on August 1. Unamortized bond discount and issue cost applicable to the 11% bonds were $120,000 and $30,000, respectively. Instructions Prepare the journal entries necessary to record issue of the new bonds and the refunding of the bonds.
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E14-14 (Entries for Retirement and Issuance of Bonds) On June 30, 2002, Mendenhal Company issued 12% bonds with a par value of $600,000 due in 20 years. They were issued at 98 and were callable at 104 at any date after June 30, 2010. Because of lower interest rates and a significant change in the companys credit rating, it was decided to call the entire issue on June 30, 2011, and to issue new bonds. New 10% bonds were sold in the amount of $800,000 at 102; they mature in 20 years. Mendenhal Company uses straight-line amortization. Interest payment dates are December 31 and June 30. Instructions (a) Prepare journal entries to record the retirement of the old issue and the sale of the new issue on June 30, 2011. (b) Prepare the entry required on December 31, 2011, to record the payment of the first 6 months interest and the amortization of premium on the bonds.
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Exercises 729
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E14-15 (Entries for Retirement and Issuance of Bonds) Friedman Company had bonds outstanding with a maturity value of $500,000. On April 30, 2011, when these bonds had an unamortized discount of $10,000, they were called in at 104. To pay for these bonds, Friedman had issued other bonds a month earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bonds were issued at 103 (face value $500,000). Issue costs related to the new bonds were $3,000. Instructions Ignoring interest, compute the gain or loss and record this refunding transaction. (AICPA adapted)
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E14-16 (Entries for Zero-Interest-Bearing Notes) two following acquisitions. 1. 2.
On January 1, 2011, McLean Company makes the
Purchases land having a fair market value of $300,000 by issuing a 5-year, zero-interest-bearing promissory note in the face amount of $505,518. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $400,000 (interest payable annually).
The company has to pay 11% interest for funds from its bank. Instructions (a) Record the two journal entries that should be recorded by McLean Company for the two purchases on January 1, 2011. (b) Record the interest at the end of the first year on both notes using the effective-interest method.
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E14-17 (Imputation of Interest) Presented below are two independent situations: (a) On January 1, 2011, Spartan Inc. purchased land that had an assessed value of $390,000 at the time of purchase. A $600,000, zero-interest-bearing note due January 1, 2014, was given in exchange. There was no established exchange price for the land, nor a ready market value for the note. The interest rate charged on a note of this type is 12%. Determine at what amount the land should be recorded at January 1, 2011, and the interest expense to be reported in 2011 related to this transaction. (b) On January 1, 2011, Geimer Furniture Co. borrowed $4,000,000 (face value) from Aurora Co., a major customer, through a zero-interest-bearing note due in 4 years. Because the note was zerointerest-bearing, Geimer Furniture agreed to sell furniture to this customer at lower than market price. A 10% rate of interest is normally charged on this type of loan. Prepare the journal entry to record this transaction and determine the amount of interest expense to report for 2011.
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E14-18 (Imputation of Interest with Right) On January 1, 2010, Durdil Co. borrowed and received $500,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As consideration for the zero-interest-bearing feature, Durdil agrees to supply the customers inventory needs for the loan period at lower than the market price. The appropriate rate at which to impute interest is 8%. Instructions (a) Prepare the journal entry to record the initial transaction on January 1, 2010. (Round all computations to the nearest dollar.) (b) Prepare the journal entry to record any adjusting entries needed at December 31, 2010. Assume that the sales of Durdils product to this customer occur evenly over the 3-year period.
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E14-19 (Long-Term Debt Disclosure) At December 31, 2010, Redmond Company has outstanding three long-term debt issues. The first is a $2,000,000 note payable which matures June 30, 2013. The second is a $6,000,000 bond issue which matures September 30, 2014. The third is a $12,500,000 sinking fund debenture with annual sinking fund payments of $2,500,000 in each of the years 2012 through 2016. Instructions Prepare the required note disclosure for the long-term debt at December 31, 2010.
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*E14-20 (Settlement of Debt) Strickland Company owes $200,000 plus $18,000 of accrued interest to Moran State Bank. The debt is a 10-year, 10% note. During 2010, Stricklands business deteriorated due to a faltering regional economy. On December 31, 2010, Moran State Bank agrees to accept an old machine and cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, and a fair market value of $180,000. Instructions (a) Prepare journal entries for Strickland Company and Moran State Bank to record this debt settlement. (b) How should Strickland report the gain or loss on the disposition of machine and on restructuring of debt in its 2010 income statement?
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730 Chapter 14 Long-Term Liabilities
(c) Assume that, instead of transferring the machine, Strickland decides to grant 15,000 shares of its common stock ($10 par) which has a fair value of $180,000 in full settlement of the loan obligation. If Moran State Bank treats Stricklands stock as a trading investment, prepare the entries to record the transaction for both parties.
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*E14-21 (Term Modification without GainDebtors Entries) On December 31, 2010, the American Bank enters into a debt restructuring agreement with Barkley Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $3,000,000 note receivable by the following modifications: 1. 2. 3. Reducing the principal obligation from $3,000,000 to $2,400,000. Extending the maturity date from December 31, 2010, to January 1, 2014. Reducing the interest rate from 12% to 10%.
Barkley pays interest at the end of each year. On January 1, 2014, Barkley Company pays $2,400,000 in cash to Firstar Bank. Instructions (a) Will the gain recorded by Barkley be equal to the loss recorded by American Bank under the debt restructuring? (b) Can Barkley Company record a gain under the term modification mentioned above? Explain. (c) Assuming that the interest rate Barkley should use to compute interest expense in future periods is 1.4276%, prepare the interest payment schedule of the note for Barkley Company after the debt restructuring. (d) Prepare the interest payment entry for Barkley Company on December 31, 2012. (e) What entry should Barkley make on January 1, 2014?
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*E14-22 (Term Modification without GainCreditors Entries) Using the same information as in E14-21 above, answer the following questions related to American Bank (creditor). Instructions (a) What interest rate should American Bank use to calculate the loss on the debt restructuring? (b) Compute the loss that American Bank will suffer from the debt restructuring. Prepare the journal entry to record the loss. (c) Prepare the interest receipt schedule for American Bank after the debt restructuring. (d) Prepare the interest receipt entry for American Bank on December 31, 2012. (e) What entry should American Bank make on January 1, 2014?
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*E14-23 (Term Modification with GainDebtors Entries) Use the same information as in E14-21 above except that American Bank reduced the principal to $1,900,000 rather than $2,400,000. On January 1, 2014, Barkley pays $1,900,000 in cash to American Bank for the principal. Instructions (a) Can Barkley Company record a gain under this term modification? If yes, compute the gain for Barkley Company. (b) Prepare the journal entries to record the gain on Barkleys books. (c) What interest rate should Barkley use to compute its interest expense in future periods? Will your answer be the same as in E14-21 above? Why or why not? (d) Prepare the interest payment schedule of the note for Barkley Company after the debt restructuring. (e) Prepare the interest payment entries for Barkley Company on December 31, of 2011, 2012, and 2013. (f) What entry should Barkley make on January 1, 2014?
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*E14-24 (Term Modification with GainCreditors Entries) Using the same information as in E14-21 and E14-23 above, answer the following questions related to American Bank (creditor). Instructions (a) Compute the loss American Bank will suffer under this new term modification. Prepare the journal entry to record the loss on Americans books. (b) Prepare the interest receipt schedule for American Bank after the debt restructuring. (c) Prepare the interest receipt entry for American Bank on December 31, 2011, 2012, and 2013. (d) What entry should American Bank make on January 1, 2014?
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*E14-25 (Debtor/Creditor Entries for Settlement of Troubled Debt) Gottlieb Co. owes $199,800 to Ceballos Inc. The debt is a 10-year, 11% note. Because Gottlieb Co. is in financial trouble, Ceballos Inc. agrees to accept some property and cancel the entire debt. The property has a book value of $90,000 and a fair market value of $140,000.
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Problems 731
Instructions (a) Prepare the journal entry on Gottliebs books for debt restructure. (b) Prepare the journal entry on Ceballoss books for debt restructure.
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*E14-26 (Debtor/Creditor Entries for Modification of Troubled Debt) Vargo Corp. owes $270,000 to
First Trust. The debt is a 10-year, 12% note due December 31, 2010. Because Vargo Corp. is in financial trouble, First Trust agrees to extend the maturity date to December 31, 2012, reduce the principal to $220,000, and reduce the interest rate to 5%, payable annually on December 31. Instructions (a) Prepare the journal entries on Vargos books on December 31, 2010, 2011, 2012. (b) Prepare the journal entries on First Trusts books on December 31, 2010, 2011, 2012.
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PROBLEMS
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P14-1 (Analysis of Amortization Schedule and Interest Entries) The following amortization and interest schedule reflects the issuance of 10-year bonds by Capulet Corporation on January 1, 2004, and the subsequent interest payments and charges. The companys year-end is December 31, and financial statements are prepared once yearly.
Amortization Schedule Year 1/1/2004 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Cash $11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 Interest $11,322 11,361 11,404 11,452 11,507 11,567 11,635 11,712 11,797 11,894 Amount Unamortized $5,651 5,329 4,968 4,564 4,112 3,605 3,038 2,403 1,691 894 Book Value $ 94,349 94,671 95,032 95,436 95,888 96,395 96,962 97,597 98,309 99,106 100,000
Instructions (a) Indicate whether the bonds were issued at a premium or a discount and how you can determine this fact from the schedule. (b) Indicate whether the amortization schedule is based on the straight-line method or the effectiveinterest method and how you can determine which method is used. (c) Determine the stated interest rate and the effective interest rate. (d) On the basis of the schedule above, prepare the journal entry to record the issuance of the bonds on January 1, 2004. (e) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transactions and accruals for 2004. (Interest is paid January 1.) (f) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transactions and accruals for 2011. Capulet Corporation does not use reversing entries.
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P14-2 (Issuance and Retirement of Bonds) Venzuela Co. is building a new hockey arena at a cost of $2,500,000. It received a downpayment of $500,000 from local businesses to support the project, and now needs to borrow $2,000,000 to complete the project. It therefore decides to issue $2,000,000 of 10.5%, 10-year bonds. These bonds were issued on January 1, 2009, and pay interest annually on each January 1. The bonds yield 10%. Venzuela paid $50,000 in bond issue costs related to the bond sale.
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732 Chapter 14 Long-Term Liabilities
Instructions (a) Prepare the journal entry to record the issuance of the bonds and the related bond issue costs incurred on January 1, 2009. (b) Prepare a bond amortization schedule up to and including January 1, 2013, using the effectiveinterest method. (c) Assume that on July 1, 2012, Venzuela Co. retires half of the bonds at a cost of $1,065,000 plus accrued interest. Prepare the journal entry to record this retirement.
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P14-3 (Negative Amortization) Good-Deal Inc. developed a new sales gimmick to help sell its inventory of new automobiles. Because many new car buyers need financing, Good-Deal offered a low down payment and low car payments for the first year after purchase. It believes that this promotion will bring in some new buyers. On January 1, 2010, a customer purchased a new $33,000 automobile, making a downpayment of $1,000. The customer signed a note indicating that the annual rate of interest would be 8% and that quarterly payments would be made over 3 years. For the first year, Good-Deal required a $400 quarterly payment to be made on April 1, July 1, October 1, and January 1, 2011. After this one-year period, the customer was required to make regular quarterly payments that would pay off the loan as of January 1, 2013. Instructions (a) Prepare a note amortization schedule for the first year. (b) Indicate the amount the customer owes on the contract at the end of the first year. (c) Compute the amount of the new quarterly payments. (d) Prepare a note amortization schedule for these new payments for the next 2 years. (e) What do you think of the new sales promotion used by Good-Deal?
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P14-4 (Issuance and Retirement of Bonds; Income Statement Presentation) Holiday Company issued its 9%, 25-year mortgage bonds in the principal amount of $3,000,000 on January 2, 1996, at a discount of $150,000, which it proceeded to amortize by charges to expense over the life of the issue on a straightline basis. The indenture securing the issue provided that the bonds could be called for redemption in total but not in part at any time before maturity at 104% of the principal amount, but it did not provide for any sinking fund. On December 18, 2010, the company issued its 11%, 20-year debenture bonds in the principal amount of $4,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2, 2011. The indenture securing the new issue did not provide for any sinking fund or for retirement before maturity. Instructions (a) Prepare journal entries to record the issuance of the 11% bonds and the retirement of the 9% bonds. (b) Indicate the income statement treatment of the gain or loss from retirement and the note disclosure required.
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P14-5 (Comprehensive Bond Problem) In each of the following independent cases the company closes its books on December 31. 1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2010. The bonds pay interest on September 1 and March 1. The due date of the bonds is September 1, 2013. The bonds yield 12%. Give entries through December 31, 2011. Titania Co. sells $400,000 of 12% bonds on June 1, 2010. The bonds pay interest on December 1 and June 1. The due date of the bonds is June 1, 2014. The bonds yield 10%. On October 1, 2011, Titania buys back $120,000 worth of bonds for $126,000 (includes accrued interest). Give entries through December 1, 2012.
2.
Instructions (Round to the nearest dollar.) For the two cases prepare all of the relevant journal entries from the time of sale until the date indicated. Use the effective-interest method for discount and premium amortization (construct amortization tables where applicable). Amortize premium or discount on interest dates and at year-end. (Assume that no reversing entries were made.)
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P14-6 (Issuance of Bonds between Interest Dates, Straight-Line, Retirement) Presented below are selected transactions on the books of Simonson Corporation. May 1, 2010 Bonds payable with a par value of $900,000, which are dated January 1, 2010, are sold at 106 plus accrued interest. They are coupon bonds, bear interest at 12% (payable annually at January 1), and mature January 1, 2020. (Use interest expense account for accrued interest.)
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Problems 733
Dec. 31 Jan. 1, 2011 April 1 Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the amortization of the proper amount of premium. (Use straight-line amortization.) Interest on the bonds is paid. Bonds of par value of $360,000 are called at 102 plus accrued interest, and retired. (Bond premium is to be amortized only at the end of each year.) Adjusting entries are made to record the accrued interest on the bonds, and the proper amount of premium amortized.
Instructions Prepare journal entries for the transactions above.
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P14-7 (Entries for Life Cycle of Bonds) On April 1, 2010, Seminole Company sold 15,000 of its 11%, 15-year, $1,000 face value bonds at 97. Interest payment dates are April 1 and October 1, and the company uses the straight-line method of bond discount amortization. On March 1, 2011, Seminole took advantage of favorable prices of its stock to extinguish 6,000 of the bonds by issuing 200,000 shares of its $10 par value common stock. At this time, the accrued interest was paid in cash. The companys stock was selling for $31 per share on March 1, 2011. Instructions Prepare the journal entries needed on the books of Seminole Company to record the following. (a) (b) (c) (d) April 1, 2010: issuance of the bonds. October 1, 2010: payment of semiannual interest. December 31, 2010: accrual of interest expense. March 1, 2011: extinguishment of 6,000 bonds. (No reversing entries made.)
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P14-8 (Entries for Zero-Interest-Bearing Note) On December 31, 2010, Faital Company acquired a computer from Plato Corporation by issuing a $600,000 zero-interest-bearing note, payable in full on December 31, 2014. Faital Companys credit rating permits it to borrow funds from its several lines of credit at 10%. The computer is expected to have a 5-year life and a $70,000 salvage value. Instructions (a) Prepare the journal entry for the purchase on December 31, 2010. (b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortization (use effective-interest method) on December 31, 2011. (c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31, 2012.
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P14-9 (Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis Cosmetics Co. purchased machinery on December 31, 2009, paying $50,000 down and agreeing to pay the balance in four equal installments of $40,000 payable each December 31. An assumed interest of 8% is implicit in the purchase price. Instructions Prepare the journal entries that would be recorded for the purchase and for the payments and interest on the following dates. (a) December 31, 2009. (b) December 31, 2010. (c) December 31, 2011. (d) December 31, 2012. (e) December 31, 2013.
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P14-10 (Comprehensive Problem: Issuance, Classification, Reporting) Presented below are four independent situations. (a) On March 1, 2011, Wilke Co. issued at 103 plus accrued interest $4,000,000, 9% bonds. The bonds are dated January 1, 2011, and pay interest semiannually on July 1 and January 1. In addition, Wilke Co. incurred $27,000 of bond issuance costs. Compute the net amount of cash received by Wilke Co. as a result of the issuance of these bonds. (b) On January 1, 2010, Langley Co. issued 9% bonds with a face value of $700,000 for $656,992 to yield 10%. The bonds are dated January 1, 2010, and pay interest annually. What amount is reported for interest expense in 2010 related to these bonds, assuming that Langley used the effectiveinterest method for amortizing bond premium and discount?
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734 Chapter 14 Long-Term Liabilities
(c) Tweedie Building Co. has a number of long-term bonds outstanding at December 31, 2010. These long-term bonds have the following sinking fund requirements and maturities for the next 6 years.
Sinking Fund 2011 2012 2013 2014 2015 2016 $300,000 100,000 100,000 200,000 200,000 200,000 Maturities $100,000 250,000 100,000 150,000 100,000
Indicate how this information should be reported in the financial statements at December 31, 2010. (d) In the long-term debt structure of Beckford Inc., the following three bonds were reported: mortgage bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in installments, secured by plant equipment $4,000,000. Determine the total amount, if any, of debenture bonds outstanding.
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P14-11 (Effective-Interest Method) Samantha Cordelia, an intermediate accounting student, is having difficulty amortizing bond premiums and discounts using the effective-interest method. Furthermore, she cannot understand why GAAP requires that this method be used instead of the straight-line method. She has come to you with the following problem, looking for help. On June 30, 2010, Hobart Company issued $2,000,000 face value of 11%, 20-year bonds at $2,171,600, a yield of 10%. Hobart Company uses the effective-interest method to amortize bond premiums or discounts. The bonds pay semiannual interest on June 30 and December 31. Compute the amortization schedule for four periods. Instructions Using the data above for illustrative purposes, write a short memo (11.5 pages double-spaced) to Samantha, explaining what the effective-interest method is, why it is preferable, and how it is computed. (Do not forget to include an amortization schedule, referring to it whenever necessary.)
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*P14-12 (Debtor/Creditor Entries for Continuation of Troubled Debt) Daniel Perkins is the sole shareholder of Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a debtor in possession, he has negotiated the following revised loan agreement with United Bank. Perkins Inc.s $600,000, 12%, 10-year note was refinanced with a $600,000, 5%, 10-year note. Instructions (a) What is the accounting nature of this transaction? (b) Prepare the journal entry to record this refinancing: (1) On the books of Perkins Inc. (2) On the books of United Bank. (c) Discuss whether generally accepted accounting principles provide the proper information useful to managers and investors in this situation.
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*P14-13 (Restructure of Note under Different Circumstances) Halvor Corporation is having financial difficulty and therefore has asked Frontenac National Bank to restructure its $5 million note outstanding. The present note has 3 years remaining and pays a current rate of interest of 10%. The present market rate for a loan of this nature is 12%. The note was issued at its face value. Instructions Presented below are four independent situations. Prepare the journal entry that Halvor and Frontenac National Bank would make for each of these restructurings. (a) Frontenac National Bank agrees to take an equity interest in Halvor by accepting common stock valued at $3,700,000 in exchange for relinquishing its claim on this note. The common stock has a par value of $1,700,000. (b) Frontenac National Bank agrees to accept land in exchange for relinquishing its claim on this note. The land has a book value of $3,250,000 and a fair value of $4,000,000. (c) Frontenac National Bank agrees to modify the terms of the note, indicating that Halvor does not have to pay any interest on the note over the 3-year period. (d) Frontenac National Bank agrees to reduce the principal balance due to $4,166,667 and require interest only in the second and third year at a rate of 10%.
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Concepts for Analysis 735
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*P14-14 (Debtor/Creditor Entries for Continuation of Troubled Debt with New Effective Interest) Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the amount of $330,000 plus $33,000 of accrued interest. The note is due today, December 31, 2010. Because Crocker Corp. is in financial trouble, D. Yaeger Corp. agrees to forgive the accrued interest, $30,000 of the principal, and to extend the maturity date to December 31, 2013. Interest at 10% of revised principal will continue to be due on 12/31 each year. Assume the following present value factors for 3 periods.
21/4% Single sum Ordinary annuity of 1 .93543 2.86989 23/8% .93201 2.86295 21/2% .92859 2.85602 25/8% .92521 2.84913 23/4% .92184 2.84226 3% .91514 2.82861
Instructions (a) Compute the new effective interest rate for Crocker Corp. following restructure. (Hint: Find the interest rate that establishes approximately $363,000 as the present value of the total future cash flows.) (b) Prepare a schedule of debt reduction and interest expense for the years 2010 through 2013. (c) Compute the gain or loss for D. Yaeger Corp. and prepare a schedule of receivable reduction and interest revenue for the years 2010 through 2013. (d) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2010, 2011, and 2012. (e) Prepare all the necessary journal entries on the books of D. Yaeger Corp. for the years 2010, 2011, and 2012.
CONCEPTS FOR ANALYSIS
CA14-1 (Bond Theory: Balance Sheet Presentations, Interest Rate, Premium) On January 1, 2011, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. Bond issue costs were not material in amount. Below are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date.
1. Bonds payable (maturing January 1, 2031) Unamortized premium on bonds payable Total bond liability 2. Bonds payableprincipal (face value $1,000,000 maturing January 1, 2031) Bonds payableinterest (semiannual payment $55,000) Total bond liability 3. Bonds payableprincipal (maturing January 1, 2031) Bonds payableinterest ($55,000 per period for 40 periods) Total bond liability
a
$1,000,000 85,800 $1,085,800 $ 142,050a 943,750b $1,085,800 $1,000,000 2,200,000 $3,200,000
b
The present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period. The present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.
Instructions (a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds. (b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000. (c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose: (1) The coupon or nominal rate. (2) The effective or yield rate at date of issue. (d) If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest? (AICPA adapted)
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736 Chapter 14 Long-Term Liabilities
CA14-2 (Various Long-Term Liability Conceptual Issues) Schrempf Company has completed a number of transactions during 2010. In January the company purchased under contract a machine at a total price of $1,200,000, payable over 5 years with installments of $240,000 per year. The seller has considered the transaction as an installment sale with the title transferring to Schrempf at the time of the final payment. On March 1, 2010, Schrempf issued $10 million of general revenue bonds priced at 99 with a coupon of 10% payable July 1 and January 1 of each of the next 10 years. The July 1 interest was paid and on December 30 the company transferred $1,000,000 to the trustee, Flagstad Company, for payment of the January 1, 2011, interest. As the accountant for Schrempf Company, you have prepared the balance sheet as of December 31, 2010, and have presented it to the president of the company. You are asked the following questions about it. 1. Why has depreciation been charged on equipment being purchased under contract? Title has not passed to the company as yet and, therefore, they are not our assets. Why should the company not show on the left side of the balance sheet only the amount paid to date instead of showing the full contract price on the left side and the unpaid portion on the right side? After all, the seller considers the transaction an installment sale. What is bond discount? As a debit balance, why is it not classified among the assets? Bond interest is shown as a current liability. Did we not pay our trustee, Flagstad Company, the full amount of interest due this period?
2. 3.
Instructions Outline your answers to these questions by writing a brief paragraph that will justify your treatment.
CA14-3 (Bond Theory: Price, Presentation, and Retirement) On March 1, 2011, Sealy Company sold its 5-year, $1,000 face value, 9% bonds dated March 1, 2011, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2011. Sealy uses the effective-interest method of amortization. Bond issue costs were incurred in preparing and selling the bond issue. The bonds can be called by Sealy at 101 at any time on or after March 1, 2012. Instructions (a) (1) How would the selling price of the bond be determined? (2) Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold. (b) What items related to the bond issue would be included in Sealys 2011 income statement, and how would each be determined? (c) Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why? (d) Assuming that the bonds were called in and retired on March 1, 2012, how should Sealy report the retirement of the bonds on the 2012 income statement? (AICPA adapted) CA14-4 (Bond Theory: Amortization and Gain or Loss Recognition) Part I. The appropriate method of amortizing a premium or discount on issuance of bonds is the effectiveinterest method. Instructions (a) What is the effective-interest method of amortization and how is it different from and similar to the straight-line method of amortization? (b) How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method differ from amounts computed under the straightline method? Part II. Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways: 1. 2. 3. Amortized over remaining life of old debt. Amortized over the life of the new debt issue. Recognized in the period of extinguishment.
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Concepts for Analysis 737
Instructions (a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt. (b) Which of the methods above is generally accepted and how should the appropriate amount of gain or loss be shown in a companys financial statements? (AICPA adapted) CA14-5 (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet. The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), their major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement, since it seemed inevitable that Ryan would begin their own can production. The Aluminum Can Company could not afford to lose the account. After some discussion a two-part plan was worked out. First, ACC was to construct the plant on Ryans land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years the plant is to become the property of Ryan. Instructions (a) What are project financing arrangements using special purpose entities? (b) What are take-or-pay contracts? (c) Should Ryan record the plant as an asset together with the related obligation? (d) If not, should Ryan record an asset relating to the future commitment? (e) What is meant by off-balance-sheet financing? CA14-6 (Bond Issue) Donald Lennon is the president, founder, and majority owner of Wichita Medical Corporation, an emerging medical technology products company. Wichita is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Donald, as owner of 51% of the outstanding stock, manages the companys operations. He places heavy emphasis on research and development and long-term growth. The other principal stockholder is Nina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasize the R & D functions and emphasize the marketing function to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wichitas stock. All of Donalds personal capital and borrowing power is tied up in his 51% stock ownership. He knows that any offering of additional shares of stock will dilute his controlling interest because he wont be able to participate in such an issuance. But, Nina has money and would likely buy enough shares to gain control of Wichita. She then would dictate the companys future direction, even if it meant replacing Donald as president and CEO. The company already has considerable debt. Raising additional debt will be costly, will adversely affect Wichitas credit rating, and will increase the companys reported losses due to the growth in interest expense. Nina and the other minority stockholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of his company, Donald is doing everything to avoid a stock issuance and is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effectiveinterest rate. Instructions (a) Who are the stakeholders in this situation? (b) What are the ethical issues in this case? (c) What would you do if you were Donald?
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738 Chapter 14 Long-Term Liabilities
USING YOUR JUDGMENT
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the books companion website, www.wiley.com/college/kieso.
Instructions
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Refer to P&Gs financial statements and the accompanying notes to answer the following questions. (a) What cash outflow obligations related to the repayment of long-term debt does P&G have over the next 5 years? (b) P&G indicates that it believes that it has the ability to meet business requirements in the foreseeable future. Prepare an assessment of its liquidity, solvency, and financial flexibility using ratio analysis.
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Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the books companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) Compute the debt to total assets ratio and the times interest earned ratio for these two companies. Comment on the quality of these two ratios for both Coca-Cola and PepsiCo. (b) What is the difference between the fair value and the historical cost (carrying amount) of each companys debt at year-end 2007? Why might a difference exist in these two amounts? (c) Both companies have debt issued in foreign countries. Speculate as to why these companies may use foreign debt to finance their operations. What risks are involved in this strategy, and how might they adjust for this risk?
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Financial Statement Analysis Cases
Case 1 Commonwealth Edison Co.
The following article appeared in the Wall Street Journal. Bond Markets Giant Commonwealth Edison Issue Hits Resale Market With $70 Million Left Over NEW YORKCommonwealth Edison Co.s slow-selling new 91/ % bonds were tossed onto the resale 4 market at a reduced price with about $70 million still available from the $200 million offered Thursday, dealers said. The Chicago utilitys bonds, rated double-A by Moodys and double-A-minus by Standard & Poors, originally had been priced at 99.803, to yield 9.3% in 5 years. They were marked down yesterday the equivalent of about $5.50 for each $1,000 face amount, to about 99.25, where their yield jumped to 9.45%.
Instructions
(a) How will the development above affect the accounting for Commonwealth Edisons bond issue? (b) Provide several possible explanations for the markdown and the slow sale of Commonwealth Edisons bonds.
Case 2
PepsiCo, Inc.
PepsiCo, Inc. based in Purchase, New York, is a leading company in the beverage industry. Assume that the following events occurred relating to PepsiCos long-term debt in a recent year. 1. The company decided on February 1 to refinance $500 million in short-term 7.4% debt to make it long-term 6%. 2. $780 million of long-term zero-coupon bonds with an effective interest rate of 10.1% matured July 1 and were paid. 3. On October 1, the company issued $250 million in Australian dollar 6.3% bonds at 102 and $95 million in Italian lira 11.4% bonds at 99.
Using Your Judgment 739
4. The company holds $100 million in perpetual foreign interest payment bonds that were issued in 1989, and presently have a rate of interest of 5.3%. These bonds are called perpetual because they have no stated due date. Instead, at the end of every 10-year period after the bonds issuance, the bondholders and PepsiCo have the option of redeeming the bonds. If either party desires to redeem the bonds, the bonds must be redeemed. If the bonds are not redeemed, a new interest rate is set, based on the then-prevailing interest rate for 10-year bonds. The company does not intend to cause redemption of the bonds, but will reclassify this debt to current next year, since the bondholders could decide to redeem the bonds.
Instructions
(a) Consider event 1. What are some of the reasons the company may have decided to refinance this short-term debt, besides lowering the interest rate? (b) What do you think are the benefits to the investor in purchasing zero-coupon bonds, such as those described in event 2? What journal entry would be required to record the payment of these bonds? If financial statements are prepared each December 31, in which year would the bonds have been included in short-term liabilities? (c) Make the journal entry to record the bond issue described in event 3. Note that the bonds were issued on the same day, yet one was issued at a premium and the other at a discount. What are some of the reasons that this may have happened? (d) What are the benefits to PepsiCo in having perpetual bonds as described in event 4? Suppose that in the current year the bonds are not redeemed and the interest rate is adjusted to 6% from 7.5%. Make all necessary journal entries to record the renewal of the bonds and the change in rate.
BRI DGE TO TH E PROFESSION
Professional Research: FASB Codification
Wie Company has been operating for just 2 years, producing specialty golf equipment for women golfers. To date, the company has been able to finance its successful operations with investments from its principal owner, Michelle Wie, and cash flows from operations. However, current expansion plans will require some borrowing to expand the companys production line. As part of the expansion plan, Wie will acquire some used equipment by signing a zero-interestbearing note. The note has a maturity value of $50,000 and matures in 5 years. A reliable fair value measure for the equipment is not available, given the age and specialty nature of the equipment. As a result, Wies accounting staff is unable to determine an established exchange price for recording the equipment (nor the interest rate to be used to record interest expense on the long-term note). They have asked you to conduct some accounting research on this topic.
Instructions
Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses. (a) Identify the authoritative literature that provides guidance on the zero-interest-bearing note. Use some of the examples to explain how the standard applies in this setting. (b) How is present value determined when an established exchange price is not determinable and a note has no ready market? What is the resulting interest rate often called? (c) Where should a discount or premium appear in the financial statements? What about issue costs?
Professional Simulation
Go to the books companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for long-term liabilities.
KWW_Professional _Simulation Long-Term Liabilities Time Remaining 4 hours 30 minutes
copy paste calculator sheet standards help
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Remember to check the books companion website to find additional resources for this chapter.
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