Lecture Intermediate accounting (IFRS/e) - Chapter 14: Bonds and long-term notes

This chapter continues the presentation of liabilities. Specifically, the discussion focuses on the accounting treatment of long-term liabilities. Long-term notes and bonds are discussed, as well as the extinguishment of debt and debt convertible into stock.

BONDS AND

LONG-TERM NOTES

Resulting from past transactions

or events.

Resulting from past transactions

or events.

Arising from present obligations

to other entities

Arising from present obligations

to other entities

 Some liabilities are not contractual obligations and

may not be payable in cash

Notice that the definition of a liability involves the

present , the future , and the past It is a present

responsibility, to transfer assets or services in the future, caused by a transaction or other event that already has

happened.

Long-Term Debt

Creditors’ interests in a company’s assets.

Obligation for future payments at specified (or

estimated) amounts, at specified (or projected) dates.

 Interest accrues on debt over time

the interest period

and/or interest payments, discounted at the

effective rate of interest at issuance.

Nature of Long-Term Debt

Obligations that extend beyond one year or the

operating cycle, whichever is longer

Obligations that extend beyond one year or the

operating cycle, whichever is longer

restrictions

Principal Value Payment

at End of Bond Term

At Bond Issuance Date

Subsequent Periods

Investor Buying Bonds

Investor Buying Bonds

Investor Buying Bonds

Bonds Sold at Par

On January 1, 2012, Masterwear Industries issued $700,000 of 12%

bonds Interest of $42,000 is payable semiannually on June 30 and December 31 The bonds mature in three years [an unrealistically short maturity to shorten the illustration] The entire bond issue was sold in a private placement to United Intergroup, at principal amount

Date Description Debit Credit

Jan 1 Investment in bonds 700,000

Cash (principal) 700,000

United - Investor

Determining the Selling Price

Below market rate (Cash received is At a discount less

than principal amount)

Equal to market rate (Cash received is At principal amount equal

to principal amount)

Above market rate (Cash received is At a premium greater

than principal amount)

Determining the Selling Price

On January 1, 2012, Masterwear Industries issued $700,000 of

12% bonds, dated January 1 Interest is payable semiannually

on June 30 and December 31 The bonds mature in three years The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup.

Present Values Interest $ 42,000 × 4.76654 = $ 200,195 Principal $700000 × 0.66634 = 466,438 Present value (price) of bonds $ 666,633

Calculation of the Price of the Bonds

Because interest is paid semiannually, the present value calculations use: (a)

the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) 6

(3 x 2) semi-annual periods.

Present value of an ordinary annuity of $1: n=6, i=7%

present value of $1: n=6, i=7%

Issued at a Discount

Date Description Debit Credit

Jan 1 Cash 666,633

Discount on bonds payable (contra liability account) 33,367 Bonds payable 700,000

Masterwear - Issuer

Date Description Debit Credit

Jan 1 Investment in bonds 700,000

Discount on bond investment 33,367 Cash 666,633

United - Investor

Determining Interest – Effective Interest

Method

Interest accrues on an outstanding debt at a constant percentage

of the debt each period Interest each period is recorded as the

effective interest rate multiplied by the outstanding balance of the

debt (during the interest period).

The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the principal value of

$700,000 The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account)

Interest is recorded as expense to the issuer and revenue to the

investor For the first six-month interest period the amount is

calculated as follows:

Outstanding Balance Effective Rate Effective Interest

Journal Entries – The Interest Method

The effective interest is calculated each period as the effective interest rate times the amount of the debt outstanding during the interest period

At the First Interest Date (June 30)

Jun 30 Interest expense 46,664

Discount on bonds payable 4,664

Change in Debt When Effective Interest

Exceeds Cash Paid

Outstanding Bonds Payable Discount Date Interest Balance (Face Value) on Bonds Jan 1 666,633 = 700,000 – 33.367

Accrued at 7%

.07 × 666,633 = 46,664 Paid at 6%

.06 × 700,000 = (42,000) Unpaid

46,664 – 42,000 = (4,664) Jun 30 671,297 = 700,000 – 28,703

Amortization Schedule – Discount

Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt.

Cash Effective Increase in Outstanding Date Interest Interest Balance Balance

(6% × principal (7% × Outstanding (Discount Amount) Balance) Reduction)

06/30/12 42,000 07 × 666,633 = 46,664 4,664 671,297 12/31/12 42,000

$46,664 – 42,0007% × $666,633

Amortization Schedule – Discount

Cash Effective Increase in Outstanding

(6% × principal (7% × Outstanding (Discount Amount) Balance) Reduction)

06/30/12 42,000 07 × 666,633 = 46,664 4,664 671,297 12/31/12 42,000 07 × 671,633 = 46,991 4,991 676,288 06/30/13 42,000 07 × 676,288 = 47,340 5,340 681,628 12/31/13 42,000 07 × 681,628 = 47,714 5,714 687,342 06/30/14 42,000 07 × 687,342 = 48,114 6,114 693,456 12/31/14 42,000 07 × 693,456 = 48,544 6,544 700,000

252,000 285,367 33,367

$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/14.

Zero-Coupon Bonds

These bonds do not pay interest

Instead, they offer a return in the

form of a “deep discount” from the

These bonds do not pay interest

Instead, they offer a return in the

form of a “deep discount” from the

principal amount

In some countries, these bonds are attractive to investors as tax is not paid

on the zero cash coupons!

When Financial Statements Are Prepared

Between Interest Dates

On 1/1/12, Masterwear Industries issues $700,000 face

value bonds to United Intergroup The market interest

rate is 14% The bonds have the following terms:

Face Value of Each Bond = $1,000

Maturity Date = 12/31/14 (3 years)

Stated Interest Rate = 12%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/12

On 1/1/12, Masterwear Industries issues $700,000 face

value bonds to United Intergroup The market interest

rate is 14% The bonds have the following terms: The bonds have the following terms:

Face Value of Each Bond = $1,000

Maturity Date = 12/31/14 (3 years)

Stated Interest Rate = 12%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/12

Assume Masterwear and United both have 

October 31st year­ends.

Recall the entries we prepared on June 30, 2012.

These entries will not change.

Jun 30 Interest expense 46,664

Discount on bonds payable 4,664

Year-end is on October 31, 2012, before the second

interest date of December 31, so we must accrue interest

for 4 months from June 30 to September 30.

Oct 31 Interest expense ($46,991 × 4/6) 31,327

Discount on bonds payable 3,327 Interest payable ($42,000 × 4/6) 28,000

Masterwear - Issuer

Oct 31 Interest receivable 28,000

Discount on bond investment 3,327

United - Investor

When Financial Statements Are Prepared

Between Interest Dates

Between Interest Dates

On December 31, the next interest payment date,

the following entries would be recorded.

Dec 31 Interest expense ($46,991 × 2/6) 15,664

Interest payable (from adjusting entry) 28,000 Discount on bonds payable 1,664 Cash ($700,000 × 6%) 42,000

When Financial Statements Are Prepared Between

Interest Dates

Determining interest by allocating the discount (or premium) on a straight-line

basis is NOT permitted under IFRS,

although it is allowed under U.S GAAP

Fair Value Option

Financial liabilities that are held-for-trading must be

measured at fair value at the end of each reporting period.

A company is not required to, but has the option to

measure, non-trading financial assets and liabilities,

including bonds and notes, at fair value if any of the

following conditions exist.

◦An accounting mismatch exists between financial assets and

financial liabilities

◦Management of financial assets and liabilities requires the use of fair value information

◦The financial liability contains an embedded derivative and the

issuer is permitted to measure, the hybrid instrument comprising the host and embedded derivative, at fair value

Fair Value Option

IFRS is more restrictive than U.S GAAP which permits the issuer to apply the fair value option unconditionally.

The option need not be applied to all financial instruments but may be applied selectively.

If a company chooses the option to report at fair value,

then it reports changes in fair value in its income

statement

Fair value may be determined by discounting the bond’s remaining interest and principal payments by the current market interest rate for a bond with similar credit risk

characteristics

Fair Value Option – Example

Jun 30 Interest expense ($666,633 × 7% ) 46,664

Discount on bonds payable 4,664

Cash ($700,000 × 6% ) 42,000

Bonds payable $ 700,000 Less: Unamortized discount (28,703)

The June 30 entry reduced the unamortized discount to $28,703 and

increased the book value of the liability by to $671,297

From our earlier example on Masterware, assume that on June 30,

2012, the market interest rate dropped to 11% (5.5% semiannually) Masterwear would report the increase in fair value from $666,633 to

$714,943, or $48,310 (refer to slide 8 for method):

At June 30, 2012, record interest and coupon as per normal:

On June 30, the fair value of the bonds was $714,943

Bonds payable $ 700,000 Less: Unamortized discount (28,703) Book value 671,297 Fair value of bonds 714,943 Fair value adjustment needed (43,646)

Fair Value Option – Example

Rather than increasing the bonds payable account itself, we increase

it indirectly with a valuation allowance (or contra) account:

Jun 30 Unrealized loss 43,646

Fair value adjustment 43,646

The $43,646 credit to fair value adjustment will increase the bond

credit balance to $714,943 Masterwear must also recognize the loss

in the income statement

Debt Transaction Costs

Debt Transaction Costs

Debt transaction costs are recognized as yield adjustments to the effective

interest rate

Transaction costs that are an integral part of the effective interest rate

are amortized, together with premiums or discounts, over the

expected life of the debt or the period in which the benefits relating to the cost are realized, whichever is shorter

Long-Term Notes

Present value techniques are used

for valuation and interest recognition.

The procedures are similar to those

we encountered with bonds

Long-Term Notes

On January 1, 2012, Skill Graphics, a product labeling and

graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note Interest of $42,000 was payable semiannually on June 30 and December 31.

Date Description Debit Credit

Jan 1 Cash 700,000

Notes payable 700,000

Skill Graphics (Borrower)

At Issuance

Date Description Debit Credit

Jan 1 Notes receivable 700,000

Cash 700,000

First BancCorp (Lender)

Long-Term Notes (continued)

At Each of the Six Interest Dates

Date Description Debit Credit

Interest expense 42,000 Cash 42,000

Skill Graphics (Borrower)

Date Description Debit Credit

Cash 42,000 Interest revenue 42,000

First BancCorp (Lender)

At Maturity

Date Description Debit Credit

12/31/14 Notes payable 700,000

Skill Graphics (Borrower)

Date Description Debit Credit

12/31/14 Cash 700,000

First BancCorp (Lender)

Note Exchanged for Assets or Services

Present Values Interest $ 42,000 × 4.76654 = $ 200,195 Principal $700000 × 0.66634 = 466,438 Present value (price) of note $ 666,633

present value of $1: n=6, i=7%

Present value of an ordinary annuity of $1: n=6, i=7%

Skill Graphics purchased a package labeling machine from Hughes–Barker company by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually The machine could have been

purchased at a cash price of $666,633 The cash price Implies an

annual market rate of interest of 14% That is, 7% is the semiannual

discount rate that yields a present value of $666,633 for the note’s

cash flows (interest plus principal) computed as follows:

The accounting treatment is the same whether the amount is

determined directly from the market value of the machine (and thus the note, also) or indirectly as the present value of the note (and thus

Note Exchanged for Assets or Services

At the Purchase Date (January 1)

Jan 1 Notes receivable 700,000

Discount on notes receivable 33,367 Sales revenue 666,633

Jun 30 Interest expense 46,664

Discount on notes payable 33,367 4,644

Installment Notes

present value tables.

Effective interest rate

× Outstanding balance of debt Interest expense or revenue

Cash amount – Interest component Principal reduction per period

o To compute cash payment use

present value tables.

o Interest expense or revenue:

Effective interest rate

× Outstanding balance of debt Interest expense or revenue

o Principal reduction:

Cash amount – Interest component Principal reduction per period

$666,633 ÷ 4.76654 = $139,857

Notes often are paid in installments, rather than a single amount at maturity

Early Extinguishment of Debt

Debt retired at maturity results

in no gains or losses

Debt retired at maturity results

in no gains or losses

Debt retired before maturity may result in an

gain or loss on extinguishment.

Cash Proceeds – Book Value = Gain or Loss

Debt retired before maturity may result in an

gain or loss on extinguishment.

Cash Proceeds – Book Value = Gain or Loss

BUT

Early Extinguishment

Illustration – On January 1, 2013, Masterwear Industries called

its $700,000, 12% bonds when their carrying amount was

$676,290 The indenture specified a call price of $685,000 The

bonds were issued previously at a price to yield 14%.

$685,000 – 676,290 ($700,000 – 676,290

Financial Statement Disclosures

Long­Term Debt

Long-term liabilities

Matrix Ltd Partial Balance Sheet December 31, 2012

For all long-term borrowing, disclosures should

include the aggregate amounts maturing and

sinking fund requirement, if any, for each of the

next five years.

Rate of return on

shareholders’ equity

Net income Shareholders’ equity

=

Rate of return

on assets

Net income Total assets

=