Intermediate Accounting II

1
Chapter 14

• Intermediate Accounting II
• Otto Chang
• Professor of Accounting

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

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

4
Accounting for Bonds Issuance

• Between interest dates, issued at premium
• Cash 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

5
Effective Interest Method

• Example 10 5-yr 10,000 bonds sold at 108,530
• to yield 6
• Cash Interest Premium
  Carrying
• Date Paid Expense Amortized
  Value
• 1/1/98
  108,530
• 7/1/98 4,000 3,256 744
  107,786
• 1/1/99 4,000 3,234 766
  107,020
• 7/1/99 4,000 3,211 789
  106,231
• Interest expense carrying value x yield rate
• Premium amortized cash paid - interest expense

6
Journal entries

• To record bond issuance on 1/1/98
• Cash 108,530
• Premium on B/P 8,530
• Bonds payable 100,000
• To record payment of interest on 7/1/98
• Interest Expense 3,256
• Premium on B/P 744
• Cash 4,000

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

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

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

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

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

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
• Cs 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
• FASBs requirement footnote disclosure

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

14
Accounting for Troubled Debts

• Impairment loss probable before maturity
• Journal entries
• Creditor
  Debtor
• Bad 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

15
Impairment Example

• On 12/31/93 received a 5-year, non-interest-bearin
  g 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)

16
Restructuring at Maturity Date

• Settlement of debt at less than carrying value
• Example debtor gave land (book value 21,000,
  FMV16,000) to settle N/P of 20,000
• Creditor
  Debtor
• Land 16,000 N/P
  20,000
• B/D allowance 4,000 Loss on land 5,000
• N/P 20,000 Land
  21,000
• 
  Gain on debt 4,000

17
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.

18
Modification of Terms-continued

• Debtors 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.

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) gt
  10,500,000
• 2,880,000 9,000,000 x 8 x 4

20
Debtors 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) 356,056
• Interest Expense 363,944
• Cash
  720,000
• 10,500,000 x 3.46613
• Journal entry to record payment of principal
• Notes Payable 9,000,000
• Cash 9,000,000

21
Creditors 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 12/31/99
• Cash 720,000
• Allowance for B/D 228,789
• Interest Revenue
  948,789
• 7,906,572 x 12

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) lt
  10,500,000 by 1,260,000
• 2,240,000 7,000,000 x 8 x 4

23
Accounting Treatment for Debtor

• Recognize extraordinary gain of 1,260,000
• Notes 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 12/31/2002
• Notes Payable 7,000,000
• Cash 7,000,000

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 12/31/99
• Cash 560,000
• Allowance for B/D 177,947
• Interest Revenue 737,947
• 6,149,556 x 12