Chang, Otto 1

Chapter 14

Intermediate Accounting II

Otto Chang

Professor of Accounting

Chang, Otto 2

Types of Bonds• Secured and Unsecured (debenture) Bonds• Term, Serial, Callable Bonds• Convertible (into other securities) Bonds,

Commodity-Backed (Asset-Linked) Bonds,• Deep Discounted (Zero Interest Debenture)

Bonds• Registered and Bearer (Coupon) Bonds• Income and Revenue Bonds: interest paid

from income or special revenues

Chang, Otto 3

Valuation of Bonds Payable• Face value, par value, principal Amount,

maturity value• Stated, coupon, nominal rate• effective yield, market rate• Discount: when stated rate is less than

effective yield• Premium: when stated is higher than effective

yield

Chang, Otto 4

Accounting for Bonds Issuance

• Between interest dates, issued at premiumCash 104

Premium on Bonds Payable 3

Bonds Payable 100

Bond Interest Expense 1

• Amortization of Premium or Discount– Straight-line over life of the bonds– Effective interest method

Chang, Otto 5

Effective Interest Method

Example: 10% 5-yr $10,000 bonds sold at $108,530 to yield 6%

Cash Interest Premium CarryingDate Paid Expense Amortized Value1/1/98 $108,5307/1/98 $4,000 $3,256 $744 107,7861/1/99 4,000 3,234 766 107,0207/1/99 4,000 3,211 789 106,231Interest expense = carrying value x yield ratePremium amortized = cash paid - interest expense

Chang, Otto 6

Journal entries

• To record bond issuance on 1/1/98Cash $108,530

Premium on B/P 8,530

Bonds payable 100,000

• To record payment of interest on 7/1/98Interest Expense $3,256

Premium on B/P 744

Cash $4,000

Chang, Otto 7

Classification of Discount or Premium

• Discount and Premium on B/P are contra accounts. They should be reported as a direct deduction from or addition to the face amount of the bonds on the balance sheet:Long-term Liabilities:

Bonds Payable XXXX (face amount)

Less: Discount on B/P XX

Net Carrying amount of B/P

Chang, Otto 8

Costs of Issuing bonds

• Costs such as printing, legal and accounting fee, commissions, and promotion fees can be deferred and amortized over the life of bonds. Example:Cash 103,000

Unamortized Bond Issue Cost 2,000

Premium on Bonds Payable 5,000

Bonds Payable 100,000

Chang, Otto 9

Extinguishment of Long-Term Debts

• The difference between the requisition cost and the net carrying amount of bonds (net of unamortized issue cost) is extraordinary gain or loss. Example:Bonds Payable $800,000 Loss on Redemption 32,000 Discount on Bonds Payable 14,400 Unamortized Bonds Issue Cost 9,600 Cash 808,000

Chang, Otto 10

In-Substance Defeasance

• Placing purchased securities in an irrevocable trust, the principal and interest of which are pledged to pay off own debt

• Question: is the debt extinguished?

• Answer: No– The debtor is not legally released from being

the primary obligator under the liability, either judicially or by the creditor

Chang, Otto 11

Notes Payable

• Accounting similar to bonds payable.

• Notes issues for cash and other rights or for property, goods, and services : record N/P and related discount to reflect fair value exchanged

• Discount calculated at the imputed interest rate, which is usually the incremental borrowing rate

Chang, Otto 12

Off-Balance-Sheet Financing

• Project financing arrangement– A and B form a new entity C– C borrows funds to construct a plant to provide

goods or services to A & B– C’s debt is guaranteed by A & B through

unconditional purchase obligations such as take-or-pay (for goods) or through-put (for service) contract

– Advantage: A & B report no liability • FASB’s requirement: footnote disclosure

Chang, Otto 13

Other Disclosure Required for Long-Term Debts

• Future payment for sinking fund and maturity amount of long-term debts during the next five years

Chang, Otto

Accounting for Troubled Debts• Impairment: loss probable before maturity• Journal entries:

Creditor DebtorBad Debt Expense xxx No entry Allowance for Bad Debt xxx

• Loss = PV* of revised future cash flow- carrying value* discounted at historical rate

• Interest revenue should be computed based on new carrying amount

Chang, Otto

Impairment: Example

• On 12/31/93 received a 5-year, non-interest-bearing note to yield at 10%

• On 12/31/95, it is determined that only $300,000 can be collected at maturity

• Loss recognized by creditor on 12/31/95:PV of future cash $300.000 x 0.7512 = $225,396

Less: carrying value on 12/31/95 375,657

Bad debt expense recognized ($150,261)

Chang, Otto

Restructuring at Maturity Date

• Settlement of debt at less than carrying value• Example: debtor gave land (book value

$21,000, FMV=$16,000) to settle N/P of $20,000Creditor DebtorLand 16,000 N/P 20,000B/D allowance 4,000 Loss on land 5,000 N/P 20,000 Land 21,000 Gain on debt 4,000

Chang, Otto

Continuation of Debt with Modified Terms

• Example: reduction in interest rate or principal, extension of maturity date, forgiving of accrued interest

• Creditor: Recognize loss based on PV of restructured cash flow. Recognize interest revenue based on new recorded value and original effective rate.

Chang, Otto

Modification of Terms-continued

• Debtor’s accounting treatment:– Carrying amount of debt is less than revised

future cash flow: Recognize no gain on restructure. Determine new effective interest rate to be used in recording interest expense.

– Carrying amount of debt is greater than total future cash flows: Recognize gain on restructure. Recognize no interest expense over the remaining life of the debt.

Chang, Otto 19

Example I: No Gain for Debtor

• On 12/31/98 a bank restructures a $10,500,000 loan issued at par (interest paid to date) by:– reducing the principal to $9,000,000– extending the maturity date from 12/31/98 to

12/31/2002 (4 years later)– reducing the interest rate from 12% to 8%

• Future cash flow ($9,000,000 + $2,880,000*) > $10,500,000*2,880,000 = $9,000,000 x 8% x 4

Chang, Otto 20

Debtor’s Accounting Treatment

• The new effective rate is 3.46613%• Journal entry to record payment of interest

expense on 12/31/1999 is:N/P (reduction of principal) 356,056Interest Expense 363,944* Cash 720,000*10,500,000 x 3.46613%

• Journal entry to record payment of principalNotes Payable 9,000,000 Cash 9,000,000

Chang, Otto 21

Creditor’s Accounting Treatment

• The PV of Future Cash Flow is $7,906,572• To record Bad debt expense on 12/31/98

Bad Debt Expense 2,593,428* Allowance for B/D 2,593,428* $10,500,000 - $7,906,572

• To record Interest revenue on 12/31/99Cash 720,000Allowance for B/D 228,789 Interest Revenue 948,789** 7,906,572 x 12%

Chang, Otto 22

Example 2: Gain for Debtor

• On 12/31/98 a bank restructures a $10,500,000 loan issued at par (interest paid to date) by:– reducing the principal to $7,000,000– extending the maturity date from 12/31/98 to

12/31/2002 (4 year later)– reducing the interest rate from 12% to 8%

• Future cash flow ($7,000,000 + $2,240,000*) < $10,500,000 by $1,260,000*2,240,000 = 7,000,000 x 8% x 4

Chang, Otto 23

Accounting Treatment for Debtor

• Recognize extraordinary gain of $1,260,000Notes Payable 1,260,000 Gain on Restructuring of Debt 1,260,000

• Record payment of “interest expense”Notes Payable 560,000 Cash 560,000

• Record payment of principle on 12/31/2002Notes Payable 7,000,000 Cash 7,000,000

Chang, Otto 24

Accounting Treatment for Creditor

• PV of future cash flow is $6,149,556• Record bad debt expense on 12/31/98

Bad Debt Expense 4,350,444 Allowance for B/D 4,350,444

• Record interest revenue on 12/31/99Cash 560,000Allowance for B/D 177,947 Interest Revenue 737,947** $6,149,556 x 12%