14-1

PREVIEW OF CHAPTER 14

Intermediate Accounting
16th Edition
Kieso ● Weygandt ● Warfield
14-2
 14 Long-Term Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the nature of bonds 4 Describe the accounting for the
and indicate the accounting for fair value option.
bond issuances.
5 Indicate how to present and
2 Describe the accounting for the analyze long-term debt.
extinguishment of debt.
3 Explain the accounting for long-
term notes payable.

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 BONDS PAYABLE

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.

Examples:
► Bonds payable ► Pension liabilities
► Long-term notes payable ► Lease liabilities
► Mortgages payable
Long-term debt has various
covenants or restrictions.

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 BONDS PAYABLE

Issuing Bonds
◆ Bond contract known as a bond indenture.
◆ Represents a promise to pay:
1. sum of money at designated maturity date, plus
2. periodic interest at a specified rate on the maturity amount
(face value).
◆ Paper certificate, typically a $1,000 face value.
◆ Interest payments usually made semiannually.
◆ Used when the amount of capital needed is too large for one
lender to supply.

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 BONDS PAYABLE

Types of Bonds
Common types found in practice:
◆ Secured and Unsecured (debenture) bonds.

◆ Term, Serial, and Callable bonds.

◆ Convertible, Commodity-Backed, Deep-Discount bonds.

◆ Registered and Bearer (Coupon) bonds.

◆ Income and Revenue bonds.

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 Valuation and Accounting for Bonds Payable

Issuance and marketing of bonds to the public:

◆ Usually takes weeks or months.
◆ Issuing company must
► Arrange for underwriters.

► Obtain SEC approval of the bond issue, undergo

audits, and issue a prospectus.

► Have bond certificates printed.

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 Valuation and Accounting for Bonds

Selling price of a bond issue is set by the

◆ supply and demand of buyers and sellers,
◆ relative risk,
◆ market conditions, and
◆ state of the economy.

Investment community values a bond at the present

value of its expected future cash flows, which consist of
(1) interest and (2) principal.

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 Valuation and Accounting for Bonds

Interest Rate
◆ Stated, coupon, or nominal rate = Rate written in the
terms of the bond indenture.

► Bond issuer sets this rate.

► Stated as a percentage of bond face value (par).

◆ Market rate or effective yield = Rate that provides an

acceptable return commensurate with the issuer’s risk.

► Rate of interest actually earned by the bondholders.

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 Valuation and Accounting for Bonds

How do you calculate the amount of interest that is actually

paid to the bondholder each period?

(Stated Rate x Face Value of the Bond)

How do you calculate the amount of interest that is actually

recorded as interest expense by the issuer of the bonds?

(Market Rate x Carrying Value of the Bond)

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 Valuation and Accounting for Bonds

Assume Stated Rate of 8%

Market Interest Bonds Sold At

6% Premium

8% Par Value

10% Discount

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LO 1
 Valuation and Accounting for Bonds

Notes:

• 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.

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 Valuation and Accounting for Bonds

Illustration: ServiceMaster Company 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.

ILLUSTRATION 14-1
Time Diagram for Bond Cash Flows

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 Valuation and Accounting for Bonds
ILLUSTRATION 14-1

ILLUSTRATION 14-2
Present Value Computation of Bond Selling at a Discount
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 WHAT DO THE NUMBERS MEAN? HOW’S
WHAT’S YOUR MY RATING?
PRINCIPLE
Two major publication companies, Moody’s Investors Service and Standard &
Poor’s Corporation, issue quality ratings on every public debt issue. The table
to the right summarizes the ratings issued by Standard & Poor’s, 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. 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 bond’s rating is upgraded
or downgraded. Unfortunately, the median rating of companies assessed by
Standard & Poor’s has recently fallen from A to BBB.
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 WHAT DO THE NUMBERS MEAN? HOW’S
WHAT’S YOUR MY RATING?
PRINCIPLE
The BBB rating is the lowest possible “investment grade” or, to put it another
way, is just one notch above “junk” bond status. It should be noted that
investors who seek triple-A debt are running out of options. Standard & Poor’s
recently gave its top rating to just three U.S. industrial companies: ExxonMobil,
Johnson & Johnson, and Microsoft. Indeed, the overall decline in ratings can
be explained in part by the growing issuance of CCC-rated debt in a variety of
industry sectors, as shown in the chart to the right. Years of low interest rates
have encouraged some of the riskiest corporate borrowers to tap yield-hungry
investors to finance their growth, spurring issuance of debt that comes with
triple-C credit ratings. For investors willing to shoulder the burden of those
extra risks in exchange for heftier returns, CCC-rated bonds have been
alluring.

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LO 1
 Bonds Issued at Par on Interest Date

Illustration: Buchanan Company issues at par 10-year term

bonds with a par value of $800,000, dated January 1, 2017, and
bearing interest at an annual rate of 10 percent payable
semiannually on January 1 and July 1, it records the following
entry.

Journal entry on date of issue, Jan. 1, 2017.

Cash 800,000
Bonds Payable 800,000

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 Bonds Issued at Par on Interest Date

Journal entry to record first semiannual interest payment on

July 1, 2017.

Interest Expense 40,000

Cash 40,000
($800,000 x .10 x ½)

Journal entry to accrue interest expense at Dec. 31, 2017.

Interest Expense 40,000

Interest Payable 40,000

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 Bonds Issued at Discount on Interest Date

Illustration: If Buchanan Company issues $800,000 of bonds on

January 1, 2017, at 97, and bearing interest at an annual rate of 10
percent payable semiannually on January 1 and July 1, it records
the issuance as follows.

Cash ($800,000 x .97) 776,000

Discount on Bonds Payable 24,000
Bonds Payable 800,000

Note: Assuming the use of the straight-line method, $1,200 of the discount
is amortized to interest expense each period for 20 periods ($24,000 ÷ 20).

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 Bonds Issued at Discount on Interest Date

Illustration: Buchanan records the first semiannual interest

payment and the bond discount on July 1, 2017, as follows.

Interest Expense 41,200

Discount on Bonds Payable 1,200
Cash 40,000

At Dec. 31, 2017, Buchanan makes the following adjusting entry.

Interest Expense 41,200

Discount on Bonds Payable 1,200
Interest Payable 40,000

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 Bonds Issued at Premium on Interest Date

Illustration: If Buchanan Company issues $800,000 of bonds on

January 1, 2017, at 103, and bearing interest at an annual rate of
10 percent payable semiannually on January 1 and July 1, it
records the issuance as follows.

Cash ($800,000 x 1.03) 824,000

Premium on Bonds Payable 24,000
Bonds Payable 800,000

Note: With the bond premium of $24,000, Buchanan amortizes $1,200 to

interest expense each period for 20 periods ($24,000 ÷ 20).

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 Bonds Issued at Premium on Interest Date

Illustration: Buchanan records the first semiannual interest

payment and the bond premium on July 1, 2017, as follows.

Interest Expense 38,800

Premium on Bonds Payable 1,200
Cash 40,000

At Dec. 31, 2017, Buchanan makes the following adjusting entry.

Interest Expense 38,800
Premium on Bonds Payable 1,200
Interest Payable 40,000

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 Bonds Issued Between Interest Dates

When companies issue bonds on other than the interest

payment dates,

◆ Buyers will pay the seller the interest accrued from the last
interest payment date to the date of issue.

◆ On the next semiannual interest payment date,

purchasers will receive the full six months’ interest
payment.

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 Bonds Issued Between Interest Dates

Illustration: On March 1, 2017, Taft Corporation issues 10-year

bonds, dated January 1, 2017, 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. Taft records the bond
issuance at par plus accrued interest as follows.

Cash 808,000
Bonds Payable 800,000
Interest Expense ($800,000 x .06 x 2/12) 8,000

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 Bonds Issued Between Interest Dates

On July 1, 2017, four months after the date of purchase, Taft

pays the purchaser six months’ interest and makes the following
entry.

Interest Expense 24,000

Cash 24,000

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 Bonds Issued Between Interest Dates

If, however, Taft issued the 6 percent bonds at 102, its March 1
entry would be:

Cash 824,000 *
Bonds Payable 800,000
Premium on Bonds Payable ($800,000 x .02) 16,000
Interest Expense 8,000

* [($800,000 x 1.02) + ($800,000 x .06 x 2/12)]

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 Accounting for Bonds

Effective-Interest Method
Produces a periodic interest expense
equal to a constant percentage of
the carrying value of the bonds.

ILLUSTRATION 14-4
Bond Discount and Premium Amortization Computation

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 Effective-Interest Method

Bonds Issued at a Discount

Illustration: Evermaster Corporation issued $100,000 of 8% term
bonds on January 1, 2017, due on January 1, 2022, with interest
payable each July 1 and January 1. Investors require an effective-
interest rate of 10%. Calculate the bond proceeds.

ILLUSTRATION 14-5
Computation of Discount on Bonds Payable

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 Effective-Interest Method
TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)

$100,000 x .61391 = $61,391

Face Value Factor Present Value
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 Effective-Interest Method
TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1

$4,000 x 7.72173 = $30,887

Semiannual Factor Present Value
Payment
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14-31 ILLUSTRATION 14-6 LO 1
 ILLUSTRATION 14-6

Journal entry on date of issue, Jan. 1, 2017.

Cash 92,278
Discount on Bonds Payable 7,722
Bonds Payable 100,000

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 ILLUSTRATION 14-6

Journal entry to record first payment and amortization of the

discount on July 1, 2017.

Interest Expense 4,614

Discount on Bonds Payable 614
Cash 4,000
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 ILLUSTRATION 14-6

Journal entry to record accrued interest and amortization of the

discount on Dec. 31, 2017.

Interest Expense 4,645

Interest Payable 4,000
Discount on Bonds Payable 645
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 Effective-Interest Method

Bonds Issued at a Premium

Illustration: Evermaster Corporation issued $100,000 of 8% term
bonds on January 1, 2017, due on January 1, 2022, with interest
payable each July 1 and January 1. Investors require an effective-
interest rate of 6%. Calculate the bond proceeds.

ILLUSTRATION 14-7
Computation of Premium on Bonds Payable

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 Effective-Interest Method
TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)

$100,000 x .74409 = $74,409

Face Value Factor Present Value
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 Effective-Interest Method
TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1

$4,000 x 8.53020 = $34,121

Semiannual Factor Present Value
Payment
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 ILLUSTRATION 14-8

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 ILLUSTRATION 14-8

Journal entry on date of issue, Jan. 1, 2017.

Cash 108,530
Premium on Bonds Payable 8,530
Bonds Payable 100,000

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 ILLUSTRATION 14-8

Journal entry to record first payment and amortization

of the premium on July 1, 2017.

Interest Expense 3,256

Premium on Bonds Payable 744
Cash 4,000
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 Effective-Interest Method

Accrued Interest
What happens if Evermaster prepares financial statements at the
end of February 2017? In this case, the company prorates the
premium by the appropriate number of months to arrive at the
proper interest expense, as follows.

ILLUSTRATION 14-9
Computation of Interest Expense

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 Effective-Interest Method

Accrued Interest
ILLUSTRATION 14-9

Evermaster records this accrual as follows.

Interest Expense 1,085.33

Premium on Bonds Payable 248.00
Interest Payable 1,333.33

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 Effective-Interest Method

Classification of Discount and Premium

Companies report bond discounts and bond premiums as a
direct deduction from or addition to the face amount of the
bond.

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 14 Long-Term Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the nature of bonds and 4 Describe the accounting for the
indicate the accounting for bond fair value option.
issuances.
5 Indicate how to present and
2 Describe the accounting for analyze long-term debt.
the extinguishment of debt.
3 Explain the accounting for long-
term notes payable.

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 Extinguishment of Debt

Illustration: On January 1, 2010, General Bell Corp. issued at 95

bonds with a par value of $800,000, due in 20 years. Eight years
after the issue date, General Bell calls the entire issue at 101 and
cancels it. At that time, the unamortized discount balance is
$24,000. General Bell computes the loss on redemption as follows.

ILLUSTRATION 14-11
Computation of Loss on Redemption of Bonds
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 Extinguishment of Debt

General Bell records the reacquisition and cancellation of the

bonds as follows:

Bonds Payable 800,000

Loss on Redemption of Bonds 32,000
Discount on Bonds Payable 24,000
Cash 808,000

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 WHAT’S
WHAT DO THE NUMBERS MEAN? YOUR DEBTYOUR PRINCIPLE
IS KILLING MY EQUITY

Traditionally, investors in the equity 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 share 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 company’s shares without having an appreciation for
its credit rating.” Indeed, other energy companies also felt the effect of Enron’s
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.
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 a focus on debt levels. Companies like Copel CIA (an energy distribution
company) were rewarded with improved stock ratings, based on their manageable
debt levels.
Or consider the case of Apple, which recently issued a whopping $6.5 billion
of debt while its stock continued to perform well. The reason? Apple is reporting
14-47 (continued) LO 2
 WHAT’S
WHAT DO THE NUMBERS MEAN? YOUR DEBTYOUR PRINCIPLE
IS KILLING MY EQUITY

strong profitability and good cash flows, so there is little concern that it cannot meet
its debt obligations. In contrast, other companies with high debt levels and low
ability to cover interest costs were not viewed very favorably. Among them are
Herbalife and Goodyear Tire and Rubber, the latter of which reported debt levels
several 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, Goodyear’s debt became a
huge burden, its debt rating fell to junk status, the company cut its dividend, and its
stock price dropped 80 percent. Only recently has Goodyear been able to dig out of
its debt ditch. 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 equity,
keep an eye on the liabilities.

Sources: 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; Christine Richard, “Holders of Corporate Bonds Seek Protection from Risk,”
Wall Street Journal (December 17–18, 2005), p. B4; and S. Nielson, “Ackman Says Herbalife’s Debt
Levels Are Cause for Concern,” http://finance.yahoo.com/news (December 29, 2014).
14-48
LO 2
 14 Long-Term Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the nature of bonds and 4 Describe the accounting for the
indicate the accounting for bond fair value option.
issuances.
5 Indicate how to present and
2 Describe the accounting for the analyze long-term debt.
extinguishment of debt.
3 Explain the accounting for
long-term notes payable.

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 LONG-TERM NOTES PAYABLE

Accounting for notes and bonds is quite similar.

◆ A note is valued at the present value of its future
interest and principal cash flows.

◆ Company amortizes any discount or premium over the

life of the note.

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 Notes Issued at Face Value

Illustration: Scandinavian Imports issues a $10,000, three-year

note, at face value to Bigelow Corp. The stated rate and the
effective rate were both 10 percent. Scandinavian would record the
issuance of the note as follows.

Cash 10,000
Notes Payable 10,000

Scandinavian Imports would recognize the interest incurred each

year as follows.

Interest Expense 1,000

Cash 1,000
($10,000 x 10% = $1,000)
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 Notes Not Issued at Face Value

Zero-Interest-Bearing Notes
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.

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 Zero-Interest-Bearing Notes

Illustration: Turtle Cove Company issued the three-year, $10,000,

zero-interest-bearing note to Jeremiah Company. 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.

ILLUSTRATION 14-12
Time Diagram for Zero-Interest-Bearing Note

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 Zero-Interest-Bearing Notes

Illustration: Turtle Cove Company issued the three-year, $10,000,

zero-interest-bearing note to Jeremiah Company. 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. Turtle Cove records issuance of
the note as follows.

Cash 7,721.80
Discount on Notes Payable 2,278.20
Notes Payable 10,000.00

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 ILLUSTRATION 14-13
Schedule of Note
Turtle Cove records interest expense at Discount Amortization

the end of the first year as follows.

Interest Expense 694.96

Discount on Notes Payable 694.96
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 Interest-Bearing Notes

Illustration: Marie Co. issued for cash a $10,000, three-year note

bearing interest at 10 percent to Morgan Corp. The market rate of
interest is 12 percent and the stated rate is 10%. The present value
of the note is calculated to be $9,520. Marie Co. records the
issuance of the note as follows.

Cash 9,520
Discount on Notes Payable 480
Notes Payable 10,000

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 ILLUSTRATION 14-14
Schedule of Note
Discount Amortization

Prepare the entry required at the end of the first year.

Interest Expense 1,142

Discount on Notes Payable 142
Cash 1,000
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 Special Notes Payable Situations

Notes Issued for Property, Goods, or Services

When exchanging the debt instrument for property, goods, or
services in a bargained transaction, 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 face amount is materially different from the current cash

price for the same or similar items or from the current fair
value of the debt instrument.

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 Special Notes Payable Situations

Choice of Interest Rates

If a company cannot determine the fair value of the property,
goods, services, or other rights, and if the note has no ready
market, company must approximate an applicable interest rate.

Choice of rate is affected by:

► Prevailing rates for similar instruments.

► Factors such as restrictive covenants, collateral, payment

schedule, and the existing prime interest rate.

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 Special Notes Payable Situations

Illustration: On December 31, 2017, 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, 2022, 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 Wunderlich’s credit rating, the absence of
collateral, the prime interest rate at that date, and the prevailing
interest on Wunderlich’s other outstanding debt, the company imputes
an 8 percent interest rate as appropriate in this circumstance.

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 Special Notes Payable Situations

ILLUSTRATION 14-16
Time Diagram for Interest-Bearing Note

ILLUSTRATION 14-17
Computation of Imputed Fair Value and Note Discount
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 Special Notes Payable Situations

Wunderlich records issuance of the note on Dec. 31, 2017, in

payment for the architectural services as follows.

Building (or Construction in Process) 418,239

Discount on Notes Payable 131,761
Notes Payable 550,000

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 ILLUSTRATION 14-18

Payment of first year’s interest and amortization of the discount.

Interest Expense 33,459
Discount on Notes Payable 22,459
Cash 11,000
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 Mortgage Notes Payable

A promissory note secured by a document called a mortgage

that pledges title to property as security for the loan.

◆ Most common form of long-term notes payable.

◆ Payable in full at maturity or in installments.

◆ Fixed-rate mortgage.

◆ Variable-rate mortgages.

14-64 LO 3
 14 Long-Term Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the nature of bonds and 4 Describe the accounting for
indicate the accounting for bond the fair value option.
issuances.
5 Indicate how to present and
2 Describe the accounting for the analyze long-term debt.
extinguishment of debt.
3 Explain the accounting for long-
term notes payable.

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 LONG-TERM NOTES PAYABLE

Fair Value Option

Companies have the option to record fair value in their
accounts for most financial assets and liabilities, including
bonds and notes payable.

The FASB believes that fair value measurement for financial

instruments, including financial liabilities, provides more
relevant and understandable information than amortized cost.

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 Fair Value Option

Fair Value Measurement

Non-current liabilities are recorded at fair value, with unrealized
holding gains or losses reported as part of net income.
Illustrations: Edmonds Company has issued $500,000 of 6 percent
bonds at face value on May 1, 2017. Edmonds chooses the fair
value option for these bonds. At December 31, 2017, the value of the
bonds is now $480,000 because interest rates in the market have
increased to 8 percent.

Bonds Payable 20,000

Unrealized Holding Gain or Loss—Income 20,000

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 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR
FAIR PRINCIPLE
VALUE FUN HOUSE

The move to change the accounting for financial liabilities under the fair value
option began in 2011, when Citigroup’s third-quarter earnings rose 68 percent
from a year earlier, partly due to an accounting adjustment. The accounting
adjustment was a $1.9 billion gain related to a change in the valuation of its
debt obligations. A similar situation resulted in the third quarter of 2011 for
JPMorgan. Its results were enhanced by decreasing the value of its debt, also
by $1.9 billion.
Some wondered how these banks’ net incomes increased even though
their credit ratings declined. This result seems counterintuitive—how does a
company that is actually doing worse have its income increase? Well, at that
time, fair value adjustments for liabilities under the fair value option were
recorded in income, rather than in OCI. As one expert noted, “At its worse,
bank accounting can seem like the mirrors in a fun house. Reality is reflected,
but the distortions can be large.”
So what to do? Three different viewpoints were suggested. One view was
that changes in the value of the liability should not be reported in income until
the liability is extinguished. Those who supported this position believe that the
14-68 (continued) LO 4
 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR
FAIR PRINCIPLE
VALUE FUN HOUSE

information related to reporting value changes in the liability in income (or

comprehensive income) was misleading and not useful to financial statement
users. Others argued that reporting the unrealized gains and losses related to
changes in the fair value of the liability through net income was appropriate
given many financial assets could also be reported at fair value. A third group
agreed with the fair value approach but indicated that if the change in value
was a result of a change in credit risk the unrealized gain or loss should be
reported as other comprehensive income.
As indicated in our discussion related to the accounting for the fair value
option related to financial liabilities, the FASB now requires that the unrealized
gains and losses related to changes in a company’s own credit risk be reported
in other comprehensive income. This approach has the benefit of reducing the
volatility in net income for preparers. In addition, GAAP and IFRS are now
converged with respect to the accounting for liability changes arising from
credit risk.
Sources: Floyd Norris, “Distortions in Baffling Financial Statements,” The New York Times (November
10, 2011); and Marie Leone, “The Fair Value Deadbeat Debate Returns,” CFO.com (June 25, 2009).
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LO 4
 14 Long-Term Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the nature of bonds and 4 Describe the accounting for the
indicate the accounting for bond fair value option.
issuances.
5 Indicate how to present and
2 Describe the accounting for the analyze long-term debt.
extinguishment of debt.
3 Explain the accounting for long-
term notes payable.

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 REPORTING AND ANALYZING LIABILITIES

Off-Balance-Sheet Financing
Off-balance-sheet financing is an attempt to borrow monies
in such a way to prevent recording the obligations.

Different Forms
1. Non-Consolidated Subsidiary
2. Special-Purpose Entity (SPE)
3. Operating Leases

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 Off-Balance-Sheet Financing

Rationale
► Removing debt enhances the quality of the balance sheet
and permits credit to be obtained more readily and at less
cost.
► Loan covenants often limit the amount of debt a company
may have. These types of commitments might not be
considered in computing the debt limitation.
► Some argue that the asset side of the balance sheet is
severely understated.

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 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR PRINCIPLE
OBILIGATED

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 has rules that require companies to disclose
off-balance-sheet 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 next is Best Buy Co.’s tabular disclosure of its
contractual obligations.

14-73 (continued) LO
LO 5
5
 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR PRINCIPLE
OBILIGATED

Enron’s 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
SEC rule, which
requires
companies to
report their
obligations over
a period of time,
will be extremely
useful to the
investment
community.

14-74
LO 5
 Presentation of Long-Term Debt

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.

Fair value of the debt should be disclosed.

Must disclose future payments for sinking fund requirements

and maturity amounts of long-term debt during each of the next
five years.

14-75 LO 5
 Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability

and long-run solvency are:

1. Debt to assets Total liabilities

ratio =
Total assets

The higher the percentage of liabilities to total assets, the

greater the risk that the company may be unable to meet its
maturing obligations.

14-76 LO 5
 Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability

and long-run solvency are:

Income before income taxes and

2. Times interest expense
interest =
earned Interest expense

Indicates the company’s ability to meet interest payments as

they come due.

14-77 LO 5
 Analysis of Long-Term Debt

Illustration: Target has total liabilities of $27,407 million, total

assets of $41,404 million, interest expense of $882 million,
income taxes of $1,204 million, and income from continuing
operations of $2,449 million. We compute Target’s debt to total
assets and times interest earned ratios as follows.

ILLUSTRATION 14-22
Computation of Long-Term Debt Ratios for Target

14-78 LO 5
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURING

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.”

ILLUSTRATION 14A-1
Usual Progression in
Involves one of two basic types of transactions: Troubled-Debt Situations

1. Settlement of debt at less than its carrying amount.

2. Continuation of debt with a modification of terms.

14-79 LO 6 Describe the accounting for a debt restructuring.

 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

SETTLEMENT OF DEBT
Can involve either a

◆ transfer of noncash assets (real estate, receivables, or

other assets) or

◆ the issuance of the debtor’s stock.

Creditor should account for the noncash assets or

equity interest received at their fair value.

14-80 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Transfer of Assets): American City Bank loaned

$20,000,000 to Union Mortgage Company. Union Mortgage 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.

Land 16,000,000
Allowance for Doubtful Accounts 4,000,000
Note Receivable (from Union Mortgage) 20,000,000

14-81 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Transfer of Assets): 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) 20,000,000

Loss on Disposal of Land 5,000,000
Land 21,000,000
Gain on Restructuring of Debt 4,000,000

14-82 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Granting an Equity Interest): 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.

Equity Investment 16,000,000

Allowance for Doubtful Accounts 4,000,000
Note Receivable (from Union Mortgage) 20,000,000

14-83 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Granting an Equity Interest): 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) 20,000,000

Common Stock 3,200,000
Paid-in Capital in Excess of Par-Common 12,800,000
Gain on Restructuring of Debt 4,000,000

14-84 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

MODIFICATION OF TERMS
A debtor’s serious short-run cash flow problems will lead it to
request one or a combination of the following modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the
debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.

14-85 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Example 1—No Gain for Debtor): On December 31,

2016, Morgan National Bank enters into a debt restructuring
agreement 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, 2016, to

December 31, 2020; and

3. Reducing the interest rate from 12% to 8%.

14-86 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

ILLUSTRATION 14A-2
Schedule Showing Reduction
of Carrying Amount of Note

Dec. 31, Notes Payable 356,056

2017 Interest Expense 363,944
Cash 720,000
14-87 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

ILLUSTRATION 14A-2
Schedule Showing Reduction
of Carrying Amount of Note

Dec. 31, Notes Payable 9,000,000

2020 Cash 9,000,000

14-88 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Creditor Calculations Morgan National Bank (creditor)

ILLUSTRATION 14A-3
Computation of Loss to
Morgan National Bank records bad debt Creditor on Restructuring
expense as follows:
Bad Debt Expense 2,593,428
Allowance for Doubtful Accounts 2,593,428
14-89 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

ILLUSTRATION 14A-4
Creditor Calculations Schedule of Interest and Amortization
after Debt Restructuring

Morgan reports
interest revenue
based on the
historical effective
rate.

Dec. 31, 2017

Cash 720,000
Allowance for Doubtful Accounts 228,789
Interest Revenue 948,789
14-90 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Creditor Calculations
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.

Dec. 31, 2020

Cash 9,000,000
Allowance for Doubtful Accounts 1,500,000
Notes Receivable 10,500,000

14-91 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Example 2—Gain for Debtor): 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,
2020, 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
interest), 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.

14-92 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Example 2—Gain for Debtor): Morgan

ILLUSTRATION 14A-5
(creditor) debits its Bad Debt Expense for $4,350,444. Computation of Loss to
Creditor on Restructuring

ILLUSTRATION 14A-6
14-93 Debtor and Creditor Entries to Record Gain and Loss on Note LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Example 2—Gain for Debtor): Morgan National reports

interest revenue the same as the previous example—

ILLUSTRATION 14A-7
Schedule of Interest and
Amortization after Debt
Restructuring

14-94 LO 6
 APPENDIX 14A TROUBLED-DEBT RESTRUCTURINGS

Illustration (Example 2—Gain for Debtor): Accounting for periodic

interest payments and final principal payment.

ILLUSTRATION 14A-8
Debtor and Creditor Entries to Record Periodic Interest and Final Principal Payments

14-95 LO 6
 RELEVANT FACTS - Similarities
◆ As indicated in our earlier discussions, GAAP and IFRS have similar
liability definitions, and liabilities are classified as current and non-
current.
◆ Much of the accounting for bonds and long-term notes is the same for
GAAP and IFRS.
◆ Under GAAP and IFRS, bond issue costs are netted against the carrying
amount of the bonds.

14-96 LO 7 Compare the accounting for long-term liabilities under GAAP and IFRS.
 RELEVANT FACTS - Differences
◆ Under GAAP, companies are permitted to use the straight-line method of
amortization for bond discount or premium, provided that the amount
recorded is not materially different than that resulting from effective-
interest amortization. However, the effective-interest method is preferred
and is generally used. Under IFRS, companies must use the effective-
interest method.
◆ Under IFRS, companies do not use premium or discount accounts but
instead show the bond at its net amount.

14-97 LO 7
 RELEVANT FACTS - Differences
◆ GAAP uses the term troubled-debt restructurings and has developed
specific guidelines related to that category of loans. IFRS generally
assumes that all restructurings will be accounted for as extinguishments
of debt.
◆ IFRS requires a liability and related expense or cost be recognized when
a contract is onerous. Under GAAP, losses on onerous contracts are
generally not recognized under GAAP unless addressed by an industry-
or transaction-specific requirements.

14-98 LO 7
 ON THE HORIZON
The FASB and IASB are currently involved in two projects, each of which has
implications for the accounting for liabilities. One project is investigating
approaches to differentiate between debt and equity instruments. The other
project, the elements phase of the conceptual framework project, will evaluate
the definitions of the fundamental building blocks of accounting. The results of
these projects could change the classification of many debt and equity
securities.

14-99 LO 7
 IFRS SELF-TEST QUESTION
Under IFRS, bond issuance costs, including the printing costs and
legal fees associated with the issuance, should be:
a. expensed in the period when the debt is issued.
b. recorded as a reduction in the carrying value of bonds payable.
c. accumulated in a deferred charges account and amortized over
the life of the bonds.
d. reported as an expense in the period the bonds mature or are
retired.

14-100 LO 7
 IFRS SELF-TEST QUESTION
Which of the following is stated correctly?
a. Current liabilities follow non-current liabilities on the statement of
financial position under GAAP but non-current liabilities follow current
liabilities under IFRS.
b. IFRS does not treat debt modifications as extinguishments of debt.
c. Bond issuance costs are recorded as a reduction of the carrying value
of the debt under GAAP but are recorded as an asset and amortized to
expense over the term of the debt under IFRS.
d. Under GAAP, bonds payable is recorded at the face amount and any
premium or discount is recorded in a separate account. Under IFRS,
bonds payable is recorded at the carrying value so no separate
14-101
premium or discount accounts are used. LO 7
 IFRS SELF-TEST QUESTION
All of the following are differences between IFRS and GAAP in accounting for
liabilities except:
a. When a bond is issued at a discount, GAAP records the discount in a
separate contra-liability account. IFRS records the bond net of the
discount.
b. Under IFRS, bond issuance costs reduces the carrying value of the
debt. Under GAAP, these costs are recorded as an asset and
amortized to expense over the terms of the bond.
c. GAAP, but not IFRS, uses the term “troubled debt restructurings.”
d. GAAP, but not IFRS, uses the term “provisions” for contingent liabilities
which are accrued.
14-102 LO 7
 COPYRIGHT

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14-103