Prepared by Coby Harmon University of California, Santa BarbaraIntermediate AccountingIntermediate AccountingPrepared by Coby Harmon University of California, Santa BarbaraWestmont CollegeINTERMEDIATEACCOUNTINGF I F T E E N T H E D I T I O Nkiesoweygandtwarfieldteam for success

C H A P T E R 14LONG-TERM LIABILITIESIntermediate Accounting15th EditionKieso, Weygandt, and Warfield

Long-Term DebtLong-Term Debt 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 longerExamples: Bonds PayableNotes PayableMortgages Payable

Pension Liabilities Lease LiabilitiesLong-term debt has various covenants or restrictions

BondsBond contract known as a Bond IndentureRepresents a promise to pay: sum of money at designated maturity date, plusperiodic interest at a specified rate on the maturity amount (face value)Paper certificate, typically a $1,000 face valueInterest payments usually made semi-annuallyPurpose is to borrow when the amount of capital needed is too large for one lender to supply

BondsCommon Types of BondsSecured and Unsecured (debenture) bondsTerm, Serial, and Callable bondsConvertible bonds, Commodity-backed bonds, Deep-discount bonds (Zero-interest debenture bonds)Registered bonds and bearer (coupon) bondsIncome and Revenue bonds

Issuing BondsProcedures for Issuing BondsCorporations market and issue bonds directly to the public in time consuming primary market transactionsUsually takes weeks or monthsIssuing company mustObtain approval of the Board of DirectorsArrange for underwritersObtain SEC approval of the bond issue, undergo audits, and issue a prospectusHave bond certificates printed

Issuing BondsBond PricingManagements choice of an interest rate (and other terms) associated with a bond issue is influenced by many factorsSupply and demand of buyers and sellersRelative riskMarket conditionsState of the economy

Valuation of BondsBetween the time the company sets the terms of a bond, and the time it issues the bonds, the market conditions and the financial position of the issuing corporation may change significantly, affecting the marketability of the bonds and thus their selling priceThe investment community values a bond at the present value of its expected future cash flows, which consists of Periodic interest Return of principal

Interest RatesStated, Coupon, or Nominal Rate The interest rate written in the terms of the bond indenture Market Rate or Effective Yield The interest rate that provides an acceptable return on an investment commensurate with the issuers risk characteristicsRate of interest actually earned by the bondholdersValuation of Bonds

Depends on Market Rate of interest Computation of selling price:PV of maturity value, plusPV of interest paymentsDiscounted at the market rate of interest Semi-annual interest paying bonds:Require doubling the periodsHalving the interest rateValuation of BondsCalculating the Selling Price of a Bond

Bonds Sold AtMarket Interest6%8%10%PremiumFace ValueDiscountValuation of BondsAssume Stated Rate of 8%

Like capital stock, private individuals can also buy and sell bonds in the over-the-counter secondary marketCompany NameInterest rate paid as a % of par valuePrice as a % of parInterest rate based on priceValuation of Bonds

Discount on Bonds Payable A liability valuation account, that reduces the face amount of the related liability (contra-account)Classification of Discount and PremiumAccounting for BondsPremium on Bonds Payable A liability valuation account, that adds to the face amount of the related liability (adjunct account)

Premium or discount recorded upon issuing bonds must be apportioned to interest expense over the life of the bond using one of two methods: Straight-Line Amortization Even amortization per period over the life of the bond Effective-Interest Amortization Amortization of a fixed percentage of bond carrying value FASB prefers the effective-interest approachAmortization of Discount and PremiumAccounting for Bonds

Accounting for Bonds

Accounting for Bonds

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 paymentBonds Issued Between Interest DatesAccounting for Bonds

Costs of Issuing BondsUnamortized bond issue costs are treated as a deferred charge and amortized over the life of the debtAccounting for Bonds

Extinguishment before Maturity DateReacquisition price > Net carrying amount = LossNet carrying amount > Reacquisition price = GainAt time of reacquisition, unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition dateExtinguishment of Debt

Long-Term Notes PayableAccounting is Similar to BondsA note is valued at the present value of its future interest and principal cash flowsCompany amortizes any discount or premium over the life of the note

Long-Term Notes Payable

Zero-Interest-Bearing NotesIssuing 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

Zero-Interest-Bearing Notes

Notes Issued for Property, Goods, and ServicesWhen exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless:Special Notes Payable SituationsNo interest rate is stated, orThe stated interest rate is unreasonable, orThe face amount is materially different from the current cash price for the same or similar items or from the market value of the debt instrument

Choice of Interest RatesIf a company cannot determine the fair value of the property, goods, services, or other rights, if the note has no ready market, or if the interest rate is determined to be inappropriate, the company must impute an interest rateSpecial Notes Payable SituationsThe 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

A promissory note secured by a document called a mortgage that pledges title to property as collateral (purchase money security interest) for the loanMortgage Notes PayableMost common form of long-term notes payablePayable in full at maturity or in installmentsFixed-rate mortgageVariable-rate mortgages

Fair Value OptionCompanies have the option to record most financial assets and liabilities at fair value in their accounting records, including bonds and notes payableIssuing procedures are identicalLiabilities accounted for using fair value must be re-measured at every reporting dateLiabilities are re-measured to current fair valueDifferences with prior carrying values are recognized as unrealized holding gains (or losses) and are reported as part of Net Income

An attempt to borrow monies in such a way to prevent recording the obligationsOff-Balance-Sheet FinancingDifferent Forms:Non-Consolidated SubsidiarySpecial Purpose Entity (SPE)Operating Leases

Presentation of Long-Term DebtNote 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 discount and Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five yearsPresentation and Analysis of Long-Term Debt

Usual Progression in Troubled-Debt SituationsA troubled-debt restructuring involves one of two basic types of transactions:1. Settlement of debt at less than its carrying amount2. Continuation of debt with a modification of terms

Settlement of DebtCan involve either a transfer of noncash assets (real estate, receivables, or other assets) or the issuance of the debtors stockCreditor should account for the noncash assets or equity interest received at their fair value

Modification of TermsA debtors serious short-run cash flow problems will lead it to request one or a combination of the following modifications:Reduction of the stated interest rateExtension of the maturity date of the face amount of the debtReduction of the face amount of the debtReduction or deferral of any accrued interest

RELEVANT FACTS (Similarities)As indicated in our earlier discussions, GAAP and IFRS have similar liability definitions, and liabilities are classified as current and non-currentMuch of the accounting for bonds and long-term notes is the same for 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 methodUnder IFRS, companies do not use premium or discount accounts but instead show the bond at its net amountUnder GAAP, bond issue costs are recorded as an asset. Under IFRS, bond issue costs are netted against the carrying amount of the bonds

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 debtIFRS 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

ON THE HORIZONThe 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