Intructor manual intermediate accounting 15th kiesoch14

Coverage in this chapter includes bonds payable, long-term notes payable,mortgages payable, and issues related to extinguishment of debt.. Bonds payable represent an obligation of the is

CHAPTER 14 Long-Term Liabilities

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Brief Exercises Exercises Problems

Concepts for Analysis

*This material is discussed in the Appendix to the Chapter.

ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives

Brief Exercises Exercises Problems

1 Describe the formal procedures associated

with issuing long-term debt.

2 Identify various types of bond issues 1, 2 4

3 Describe the accounting valuation

for bonds at date of issuance.

4 Apply the methods of bond discount

and premium amortization.

ASSIGNMENT CHARACTERISTICS TABLE

Time (minut es)

E14-1 Classification of liabilities Simple 15–20 E14-2 Classification Simple 15–20 E14-3 Entries for bond transactions Simple 15–20 E14-4 Entries for bond transactions—straight-line Simple 15–20 E14-5 Entries for bond transactions—effective-interest Simple 15–20 E14-6 Amortization schedule—straight-line Simple 15–20 E14-7 Amortization schedule—effective-interest Simple 15–20 E14-8 Determine proper amounts in account balances Moderate 15–20 E14-9 Entries and questions for bond transactions Moderate 20–30 E14-10 Entries for bond transactions Moderate 15–20 E14-11 Information related to various bond issues Simple 20–30 E14-12 Entry for retirement of bond; bond issue costs Simple 15–20 E14-13 Entries for retirement and issuance of bonds Simple 15–20 E14-14 Entries for retirement and issuance of bonds Simple 12–16 E14-15 Entries for retirement and issuance of bonds Simple 10–15 E14-16 Entries for zero-interest-bearing notes Simple 15–20 E14-17 Imputation of interest Simple 15–20 E14-18 Imputation of interest with right Moderate 15–20 E14-19 Fair value option Simple 10–15 E14-20 Long-term debt disclosure Simple 10–15

*E14-21 Settlement of debt Moderate 15–20

*E14-22 Term modification without gain—debtor’s entries Moderate 20–30

*E14-23 Term modification without gain—creditor’s entries Moderate 25–30

*E14-24 Term modification with gain—debtor’s entries Moderate 25–30

*E14-25 Term modification with gain—creditor’s entries Moderate 20–30

*E14-26 Debtor/creditor entries for settlement of troubled debt Simple 15–20

*E14-27 Debtor/creditor entries for modification of troubled debt Moderate 20–25

P14-1 Analysis of amortization schedule and interest entries Simple 15–20 P14-2 Issuance and retirement of bonds Moderate 25–30 P14-3 Negative amortization Moderate 20–30 P14-4 Issuance and retirement of bonds; income statement

ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Level of Difficu lty

Time (minut es)

*P14-12 Debtor/creditor entries for continuation of troubled debt Moderate 15–25

*P14-13 Restructure of note under different circumstances Moderate 30–45

*P14-14 Debtor/creditor entries for continuation of troubled debt

with new effective-interest.

LEARNING OBJECTIVES

1 Describe the formal procedures associated with issuing long-term debt

2 Identify various types of bond issues

3 Describe the accounting valuation for bonds at date of issuance

4 Apply the methods of bond discount and premium amortization

5 Describe the accounting for the extinguishment of debt

6 Explain the accounting for long-term notes payable

7 Describe the accounting for the fair value option

8 Explain the reporting of off-balance-sheet financing arrangements

9 Indicate how to present and analyze long-term debt

*10 Describe the accounting for a debt restructuring

*11 Compare the accounting procedures for long-term liabilities under GAAP and IFRS

*This material is covered in an Appendix to the chapter

CHAPTER REVIEW

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter  

1 Chapter 14 presents a discussion of the issues related to long-term liabilities Long-termdebt consists of probable future sacrifices of economic benefits These sacrifices arepayable in the future, normally beyond one year or the operating cycle, whichever islonger Coverage in this chapter includes bonds payable, long-term notes payable,mortgages payable, and issues related to extinguishment of debt The accounting anddisclosure issues related to long-term liabilities include a great deal of detail due to thepotentially complicated nature of debt instruments

Long-Term Debt

2 (L.O 1) Long-term debt consists of obligations that are   not payable within the operating

cycle or one year, whichever is longer These obligations normally require a formal agreement between the parties involved that often includes certain covenants and restrictions for

the protection of both lenders and borrowers These covenants and restrictions are found

in the bond indenture or note agreement, and include information related to amounts

authorized to be issued, interest rates, due dates, call provisions, security for the debt,sinking fund requirements, etc The important issues related to the long-term debt shouldalways be disclosed in the financial statements or the notes thereto

3 Long-term liabilities include bonds payable, mortgage notes payable, long-term notes

payable, lease obligations, and pension obligations Pension and lease obligations

are discussed in later chapters

Issuing Bonds

4 Bonds payable represent an obligation of the issuing corporation to pay a sum of money

at a designated maturity date plus periodic interest at a specified rate on the face value.The main purpose of issuing bonds is to borrow for the long term when the amount ofcapital needed is too large for one lender to supply Bond interest payments are usuallymade semiannually

5 Bonds are debt instruments of the issuing corporation used by that corporation to borrow

funds from the general public or institutional investors The use of bonds provides theissuer an opportunity to divide a large amount of long-term indebtedness among manysmall investing units

6 Bonds may be sold through an underwriter who either (a) guarantees a certain sum to the

corporation and assumes the risk of sale or (b) agrees to sell the bond issue on the basis

of a commission Alternatively, a corporation may sell the bonds directly to a largefinancial institution without the aid of an underwriter

Types of Bonds

7 (L.O 2) There are various types of bonds that can be issued, to include: term bonds,serial bonds, callable bonds, secured and unsecured bonds, convertible bonds,commodity-backed bonds, deep discount bonds, registered and coupon bonds, andincome and revenue bonds

Valuation of Bonds Payable

8 (L.O 3) Bonds are issued with a   stated rate of interest expressed as a percentage of the face value of the bonds When bonds are sold for more than face value (at

a premium) or less than face value (at a discount), the interest rate actually earned by the bondholder is different from the stated rate The issue price is based on the effective

yield or market rate of interest and is set by economic conditions in the investment

market The effective rate exceeds the stated rate when the bonds sell at a discount, andthe effective rate is less than the stated rate when the bonds sell at a premium

9 To compute the issue price of bonds, the present value of future cash flows from interestand principal must be computed

Bonds Issued at a Discount or Premium

10 (L.O 4) Discounts and premiums resulting from a bond issue are recorded at the time the 

bonds are sold The amounts recorded as discounts or premiums are amortized eachtime bond interest is paid The time period over which discounts and premiums areamortized is equal to the period of time the bonds are outstanding (date of sale tomaturity date)

11 To illustrate the recording of bonds sold at a discount or premium, the following examplesare presented If Aretha Company issued $100,000 of bonds dated January 1, 2014 at

98, on January 1, 2014, the entry would be as follows:

Cash ($100,000 × 98) 98,000Discount on Bonds Payable 2,000Bonds Payable 100,000

If the same bonds noted above were sold for 102, the entry to record the issuance would

be as follows:

Cash ($100,000 × 1.02) 102,000Premium on Bonds Payable 2,000Bonds Payable 100,000

It should be noted that whenever bonds are issued, the Bonds Payable account is alwayscredited for the face amount of the bonds issued

Straight-Line Amortization of Discount and Premium

12 To illustrate the amortization of the bond discount or premium, assume the bonds sold inthe example above are five-year bonds, and they pay interest annually Since the bondsare sold on the issue date (January 1, 2014) they will be outstanding for the full fiveyears Thus, the discount or premium would be amortized over the entire life of thebonds The entry to amortize the bond discount at the end of 2014 is:

Interest Expense 400Discount on Bonds Payable ($2,000 ÷ 5) 400The entry to amortize the premium is:

Premium on Bonds Payable 400Interest Expense 400

Note that the amortization of the discount increases the interest expense for the periodand the amortization of the premium reduces interest expense for the period

Bonds Issued Between Interest Dates

13 When bonds are issued between interest dates, the purchase price is increased by anamount equal to the interest earned on the bonds since the last interest payment date

On the next interest payment date, the bondholder receives the entire semiannual interestpayment As a result, the amount of interest expense to the issuing corporation is thedifference between the semiannual interest payment and the amount of interest prepaid

by the purchaser For example, assume a 10-year bond issue in the amount of $300,000,bearing 9% interest payable semiannually on June 30 and December 31, dated January 1,

2014 If the entire bond issue is sold at par on March 1, 2014, the following journal entrywill be made by the seller:

Cash 304,500Bonds Payable 300,000Interest Expense 4,500*

*($300,000 × 09 × 2/12)The entry for the semiannual interest payment on July 1, 2014 would be as follows:

Interest Expense 13,500Cash 13,500

The total bond interest expense for the six month period is $9,000 ($13,500 – $4,500),which represents the correct interest expense corresponding to the four-month period thebonds were outstanding

Effective-Interest Amortization

14 The profession’s preferred procedure to amortize discounts and premiums is the

effective-interest method This method computes the bond interest using the effective

rate at which the bonds are issued More specifically, interest cost for each period is theeffective interest rate multiplied by the carrying value (book value) of the bonds at the start

of the period The effective-interest method is best accomplished by preparing a Schedule

of Bond Interest Amortization This schedule provides the information necessary for eachsemiannual entry for interest and discount or premium amortization The chapter includes

an illustration of a Schedule of Bond Interest Amortization for both a discount andpremium situation

Classification of Discounts and Premiums

15 Unamortized premiums and discounts are reported with the Bonds Payable account in

the liability section of the balance sheet Premiums and discounts are not liability accounts;they are merely liability valuation accounts Premiums are added to the Bonds Payableaccount and discounts are deducted from the Bonds Payable account in the liabilitysection of the balance sheet

Accruing Interest on Bonds

16 If the interest payment date does not coincide with the financial statement’s date, theamortized premium or discount should be prorated by the appropriate number of months

to arrive at the proper interest expense Interest payable is reported as a current liability

Costs of Issuing Bonds

17 Some of the costs associated with issuing bonds include engraving and printing costs,legal and accounting fees, commissions, and promotion expenses GAAP indicates that

these costs should be debited to a deferred charge account entitled, Unamortized Bond

Issue Costs These costs are then amortized over the life of the issue in a manner similar

to that used for discount on bonds

Extinguishment of Debt

18 (L.O 5) The extinguishment, or payment, of long-term liabilities can be a relatively straight  forward process which involves a debit to the liability account and a credit to cash Theprocess can also be a complicated one when the debt is extinguished prior to maturity

-19 The reacquisition of debt can occur either by payment to the creditor or by reacquisition inthe open market At the time of reacquisition, any unamortized premium or discount, andany costs of issue related to the bonds must be amortized up to the reacquisition date toavoid misstatement of any resulting gain or loss on the extinguishment The differencebetween the reacquisition price and the net carrying amount of the debt is

a gain (reacquisition price lower) or loss (reacquisition price greater) from extinguishment

Notes Payable

20 (L.O 6) The difference between current notes payable and long-term notes payable is 

the maturity date Accounting for notes and bonds is quite similar

21 Interest-bearing notes are treated the same as bondsa discount or premium is recognized

if the stated rate is different than the effective rate Zero-interest-bearing notes have apresent value that is less than the fair value, resulting in a discount on the note Thediscount is amortized using the effective-interest method

22 When a debt instrument is exchanged for noncash consideration in a bargained

transaction, the stated rate of interest is presumed fair unless: (a) no interest rate isstated, (b) the stated interest rate is unreasonable, or (c) the stated face amount of thedebt instrument is materially different from the current cash sales price for the same orsimilar items or from the current fair value of the debt instrument If the stated rate is

determined to be inappropriate, an imputed interest rate must be used to establish the

present value of the debt instrument

23 When an imputed interest rate is used for valuation purposes, it will normally be at leastequal to the rate at which the debtor can obtain financing of a similar nature from othersources at the date of the transaction The object is to approximate the rate that wouldhave resulted if an independent borrower and an independent lender had negotiated

a similar transaction under comparable terms and conditions

24 Mortgage notes are a common means of financing the acquisition of property, plant, and

equipment in a proprietorship or partnership form of business organization Normally, thetitle to specific property is pledged as security for a mortgage note Points assessed bythe lender raise the effective interest rate above the stated rate If a mortgage note is paid

on an installment basis, the current installment should be classified as a current liability

25 Because of unusually high, unstable interest rates and a tight money supply, the traditional

fixed-rate mortgage has been partially supplanted with alternative mortgage

arrangements Variable-rate mortgages feature interest rates tied to changes in the

fluctuating market rate of interest Generally, variable-rate lenders adjust the interest rate ateither one or three-year intervals

Fair Value Option

26 (L.O 7) Companies may opt to record fair value in their accounts for most financial assetsand liabilities including bonds and notes The FASB believes the fair value measurementprovides more relevant and understandable information than amortized cost Ifcompanies choose this option, noncurrent liabilities are recorded at fair value, withunrealized holding gains or losses reported as part of net income

Off-Balance Sheet Financing

27 (L.O 8) A significant issue in accounting today is the question of off-balance-sheet financing 

Off-balance-sheet financing is an attempt to borrow monies in such a way that the

obligations are not recorded Off-balance-sheet financing can take many different forms.Some examples include (1) non-consolidated subsidiary, (2) a special purpose entity, and(3) operating leases

28 The FASB’s response to off-balance-sheet financing arrangements has been increaseddisclosure (note) requirements

Presentation of Long-Term Debt

29 (L.O 9) 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 commentsand schedules in the accompanying notes to the financial statements These footnotedisclosures generally indicate the nature of the liabilities, maturity dates, interest rates,call provisions, conversion privileges, restrictions imposed by the borrower, and assetspledged as security 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

Analysis of Long-Term Debt

30 Long-term creditors and stockholders are interested in a company’s long-run solvencyand the ability to pay interest when it is due Two ratios that provide information about

debt-paying ability and long-run solvency are the debt to total assets ratio and the

times interest earned ratio.

Troubled Debt Restructurings

*31 (L.O 10) A troubled debt restructuring occurs when a creditor “for economic or legal

reasons related to the debtor’s financial difficulties grants a concession to the debtor that

it would not otherwise consider.”

Settlement of Debt

*32 Creditor When noncash assets (real estate, receivables, or other assets) or the issuance

of the debtor’s stock is used to settle a debt obligation in a troubled debt restructuring, thenoncash assets or equity interest given should be accounted for at their respective fairvalues by the creditor The creditor must determine the excess of the receivable over thefair value of those same assets or equity interests transferred (loss)

*33 Debtor The debtor is required to determine the excess of the carrying amount of the

payable over the fair value of the assets or equity interests transferred (gain) The debtorrecognizes a gain equal to the amount of the excess, and the creditor normally wouldcharge the excess (loss) against Allowance for Doubtful Accounts In addition, the debtorrecognizes a gain or loss on disposition of assets to the extent that the fair value of thoseassets differs from their carrying amount (book value)

LECTURE OUTLINE

This chapter can be covered in three class sessions Students are generally familiar with theaccounting for bonds payable from elementary accounting Some students may be unfamiliarwith the effective-interest method of amortization of bond discount and premium This chapterprovides an opportunity to apply present value concepts covered in chapter 6 The appendixprovides a detailed discussion of troubled debt restructuring

A (L.O 1) Long-term Debt. 

1 Consists of present obligations not payable within the operating cycle of the company

or a year, whichever is longer

2 Covenants or restrictions, for the protection of both lenders and borrowers, are stated

in the bond indenture or note agreement

B (L.O 2) Types of Bonds The various types of bonds attract capital from different investors   

and risk takers and satisfy the cash flow needs of issuers

1 Discuss the different types of bonds, including term bonds, serial bonds, callablebonds, secured and unsecured bonds, convertible bonds, commodity-backed bonds,deep discount bonds, registered and coupon bonds, and income and revenue bonds

C (L.O 3) Valuation of Bonds Payable The price of a bond is determined by the 

interaction between the bond’s stated interest rate and its market rate.

1 A bond’s price is equal to the sum of the present value of the principal and the presentvalue of the periodic interest

a If the stated rate = the market rate, the bond will sell at par (face value)

b If the stated rate < the market rate, the bond will sell at a discount

c If the stated rate > the market rate, the bond will sell at a premium

T EACHING T IP Illustration 14-1 can be used to demonstrate how bond prices are affected by the stated rate

of interest and the market rate of interest A numerical example is given that calculates theselling price of bonds issued at a premium, at par, and at a discount

2 Accounting for the issuance of bonds

a The face value of the bond is always reflected in the Bonds Payable account

b When a bond sells at a discount, the difference between the sales price and theface value is debited to Discount on Bonds Payable, a contra liability account