LongTerm Liability

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LongTerm Liability

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Title: LongTerm Liability

1
Chapter 14

Long-Term Liability

2
Topics of Long-Term Liabilities

Issuance of bonds (at premiums or discount)
Issuance of bonds between interest payment dates
Extinguishment of debt
Bonds issued with detectable stock warrants
Convertible Bonds (including Induced Conversion)
Long-term Notes Payable (issued for cash and
rights or privileges)
Long-term Notes Receivable
Loan Impairment

3
Long-Term Liabilities

Present value concept
Present value of 1 is the value today of 1 to
be received at some future date, give a specific
interest rate.
Example
1. What is the present value of 100 to be
received a
year from now given the annual market interest
rate
is 10?
P.V. ? (110) 100
P.V. 100/1.1
100 ? 0.9091
90.91

4
Long-Term Liabilities

2. What is the present value of 100 to be
received
two years from now given the annual interest
rate is
10?
P.V ? (1-10) ? (110) 100
P.V ? (1-10)2 100
P.V. ? 1.21 100
P.V. 100 / 1.21
100 ? 0.8264
82.64

5
Annuity

Receiving (or paying)a constant amount of money
at the end of each period (equal time internal)
for a given number of periods

Receiving 100 every year for the following 5
years. (period 1 year) (starting a year from
now)

6
Present Value (P.V.) of an Annuity

1. Using the example above given 10 Interest
rate
P.V. of the first 100 100 ? 0.9091 90.91
P.V. of the second 100 100 ? 0.8264 82.64
P.V. of the third 100 100 ? 0.7513 75.13
P.V. of the fourth 100 100 ? 0.6830 68.30
P.V. of the fifth 100 100 ? 0.6209 62.09
Total 3.7907 379.07

7
Present Value (P.V.) of an Annuity

The P.V. of 100 annuity receiving every year for
the following 5 years, starting a year from now
gt 100 3.7907 379.07
Can be obtained from the annuity table on p386.
Table II on p386 under 10, 2 periods
2. What is the P.V. of 300 annuity receiving 30
months for the following 30 months, starting 6
months from now. The annual interest rate is 12.

8
Corporate Bonds

Securities issued by a corporation to borrow
money from public. This is a source to raise
funds. The corporation will receive cash when
bonds are issued. The face value of the bonds
must be repaid to the bondholders on the maturity
date of the bonds. Also, the bond issuers will
pay interests to the bondholders periodically
(i.e., semi-annually).
J.E. (when Bonds are issued)
Cash xxx
Bonds Payable xxx

9
Bonds Payable

Long-Term Liability if bonds nature in more than
one year.
Short-Term Liability if bonds nature in less
than one year
Bond Indenture
An agreement States
Interest rate of bonds
Interest Payment date
The maturity date of bonds
(i.e., callable, convertible, serial or term
bond..)

10
The Process of Bond Issuance

1. Receive the approval from the stockholders and
regulatory authorities (i.e., the SEC)
2. Print certificate and write indenture (to set
the terms of bond issue such as the stated
interest rate, the interest payment date and the
maturity date)
3. Make a public announcement of its intent to
sell the bonds or a particular date.
4. Negotiate the appropriate selling price with
the stockbroker or the underwriters based on the
terms of bond issue (i.e., the stated inters
rate), the general bond market conditions, the
risk of the bonds and the expected state of the
economy.

11
The Process of Bond Issuance (Contd.)

1.The stockholder will determine the rate (yield)
and thus, the selling prices that it believes
best reflects the current market conditions for a
particular bond issue. The yield is the market
rate (effective rate) for the bond issue. The
yield could be different opinion between the
stockholders and company or a change in the
economic conditions between the date the terms
were set and the date the bonds were issue).
Three possible outcomes
1. Yield stated rate gt the bonds are sold at
par
2. Yield gt stated rate gt bonds are sold at
discount
3. Yield lt stated rate gt bonds are sold at
premium

12
Units of bonds

At 1,000 denominations or a multiple of 1,000.
Price of bonds stated at 100s i.e., 1,000
issued at 98
issuing price 1,000 ? 98 980
Types of Bonds
On the Basis whether the bonds are secured
Secured bonds
Unsecured bonds (Debentures)

13
Units of bonds (Contd.)

On the basis of how the interest are paid
Registered Bonds
Coupon Bonds
On the basis of how the bonds mature
Term Bonds
serial Bonds
Convertible Bonds
Callable Bonds

14
Determination of Bond Price

The obligations of bond issuers
(1) to pay the principle (the face value) when
bonds mature or the maturity date.
(2) to pay interest periodically (i.e.,
semiannually or annually) over the life the
bond.
Bond price the cash received by the issuer from
the issuance of the bonds.
Bond Price the present value of the bond.

15
Determination of Bond Price (Contd.)

Present value of bondsgt The sum of
(1) the present value of the principal received
on the maturity date
(2) the present value of the periodic interests
(an annuity).
Discount rate effective rate market rate
depending on the riskyness of the issuers (the
issuing company)
In general a higher risk will result in a higher
effective rate (discount rate).

16
Determination of Bond Price (Contd.)

Bonds Issued at Face Value
(When the stated interest rate equals the
effective interest rate, the bond price will
equal the face value.)
Example (10 period)
Page company will issued a 5-year term bond with
face amount 100,000 and stated interest rate 10
(annual rate). The interest are paid
semiannually. Assume that the effective interest
rate demanded by investors for bonds of this
level of risk is also 10 (annual rate) what is
the present value of the bond (the bond price)?

17
Determination of Bond Price (Contd.)

(1)P.V. of the principal (100,000 mature in 5
years,
discount rate 5, 10 periods)
The annual effective rate 10 (10/2 5)
100,000 ? 0.6139 61,390
(2)P.V. of the interest received semiannually for
10
periods (annuity, discount rate 5, 10
periods)
5,00 ? 7.7217 38,608.5
annuity table, 5, 10periods

18
Determination of Bond Price (Contd.)

The P.V. of the bond the sum of (1) and (2)
(1) (2)
61,390 38,608.5 100,000
The semiannual interest
100,000 ? 10 ? 1/2 5,000
the annual stated interest rate, not the
effective rate!!

19
Determination of Bond Price (Contd.)

Therefore, when the stated rate equals the
effective
rate (the discount rate), the bond price (the
P.V. of
bonds) equals the face value.
J.E. (when bonds are issued at face value)
Cash 100,000
Bonds payable 100,000

20
Determination of Bond Price (Contd.)

Question
Whats is the total interest expense of the bond
(issued at face value)?
Cash payments by the issuer (150,000)
Cash Received from issuing the bond 100,000
Interest Expense (50,000)
Principal on maturity date semiannual
interest payments
100,000 5,000 x 10
150,000

21
Bond Issued at a Discount

When the stated interest rate is less than the
effective interest rate, the present value of a
bond will be less than its face value.
Example 2 Use the same example as on page 16,
except that the effective rate is 12, rather
than 10 as in the example on page 16.

22
Bond Issued at a Discount (Contd.)

What is the semiannual interest received by
bondholders?
100,000 x 10 ? 1/2 5,000
What is the discount rate used to compute the
P.V. of the bond?
12 (the annual effective rate) if interests are
paid annually. (5 periods)
6 (this semiannual effective) if interest are
paid semiannually. (10 periods)

23
Bond Issued at a Discount (Contd.)

Compute the present value of the bond
Since the interest are paid semiannually, the
discount rate will be 6 with 10 periods.
(1)P.V. of the principal 100,000 ?.5584
55,840
P.V. table, 6, 10periods
(2) P.V. of the semiannual interest
5,000 ? 7.3601 36,800.5
Annuity table, 6, 10periods
P.V. of the bond (1) (2)
55,840 36,800.5 92,640.5

24
Bond Issued at a Discount (Contd.)

92,640.5 lt 100,000 (Discount 7359.5)
P.V. of bond lt Face vale
gt when the stated rate is less than the
effective rate (i.e., 10 lt 12), the P.V. of
the bond will be less than the face value.
Example 2.
J.E. (when bonds are issued at discount)
Cash 92,640.5
Discount on Bonds 7,359.5
Bonds Payable 100,000

25
Bond Issued at a Discount (Contd.)

Question
What is the total interest expense of this bond
(issued at Discount)?
Cash payment by the corporation for the bond
(150,000)
Cash received from issuing the bond (at Discount)
92,640.5
Interest Expense 59,359.50
Discount would increase the actual interest
expense and need to be amortized over the life of
the bond
Principal on maturity date semiannual
interest payments
100,000 50,000 150,000
Interest Expense interest payment Discount
50,000 7,359.50 57,359.50

26
Bond Issued at Premium

When the stated interest rate is higher than the
effective interest rate demanded by the investors
for the level of the risk of the bonds, the
present value of the bonds would be greater than
its face value.
Examples use the same example as on page 16,
except the effective interest rate is 8. (the
stated interest rate is still at 10) What is the
semiannual interest received by bondholder?
100,000 ? 10 ? 1/2 5,000

27
Bond Issued at Premium (Contd.)

What is the discount rate used to compute the
P.V. of the bond?
8 (the annual effective rate is interests are
paid annually) (5 periods)
4 (the semiannual effective rate if interests
are paid semiannually) (10 periods)

28
Bond Issued at Premium (Contd.)

Compute the P.V. of the bond
Since the interests are paid semiannually, the
discount rate would be 4 and the discounting
periods are 8 periods.
(1) P.V. of the principal
100,000 x 0.6756 67,560

29
Bond Issued at Premium (Contd.)

(2) P.V. of the semiannual interest
5,000 x 8.1109 40,554.5
P.V. of the bond (1) (2)
67,560 40,554.5 108,114.5
108,114.5 gt 100,000 (Premium 8,114.5)
P.V. of Bond face value
gt When the stated rate is greater than the
effective rate (i.e., 10, gt 8), the P.V. of
bonds would be greater than the face value of the
bond.

30
Bond Issued at Premium (Contd.)

Example 3
J.E. (When Bonds are issued at Premium)
Cash 108,114.5
Bonds Payable 100,000
Premium on Bonds Payable 8,114.50
Question What is the total interest expense of
the bond (issued at Premium)?
Cash payments by the issuer (150,000)
Cash received from issuing the bond
108,114.5
Interest Expense (41,885.5)

31
Bond Issued at Premium (Contd.)

Interest Expense interest payments - Premium
5,000 x 10 - 8,114.5
41,885.5
(Premium will decrease the interest expense.)
A premium Account an adjunct account to the
Bonds Payable account and is share as an addition
to the bonds Payable account.

32
Bond Issued at Premium (Contd.)

A Discount Account a contra account to the Bonds
Payable and is share as a deduction from the
Bonds Payable
Book value (carrying value) of the bond issued
the face value plus any unamortized premiums or
minus any unamortized discounts. If an effective
interest method is used to amortized the discount
(or premium), the carrying value equals the
present value (using the historical effective
interest rate)

33
Accounting for Bonds Payable

The information of example 1 on page 16 is
summarized below with same additional
information
Issuing Company Page Company
Stated Interest 10 (annual)
Effective Interest 10 (annual)
Date of Issuance 2/1/87
Date of Maturity 2/1/92
Interest Payment Dates 2/1 and 8/1
Face Value 100,000
P.V. of the Bond 100,000

34
Accounting for Bonds Payable (Contd.)

J.E.
2/1/89 Cash 100,000
B/P 100,000
8/1/97 Interest Expense 5,000
Cash 5,000
12/31/87 Adjusting entry for 5-month interest
expense occurred but not paid. The interest
payment dates are 2/1 and 8/1).
Interest Expense 4,167
Interest payable 4,167

35
Accounting for Bonds Payable (Contd.)

(Reversing Entry)
1/1/88 Interest Payable 4,167
Interest Expense 4,167
2/1/88 Interest Expense 5,000
Cash 5,000
(If without the reversing entry on 1/1/88, the
J.E. of 2/1/88 would be
Interest Expense 833
Interest Payable 4,167
Cash 5,000

36
Accounting for Bonds Payable (Contd.)

8/1/88 Interest Expense 5,000
Cash 5,000
12/31/88
Adjusting entry for the 5-month unrecorded
interest
expense
Interest Expense 4,167
Interest payable 4,167

37
Accounting for Bonds Payable (Contd.)

1/1/89 Reversing Entry
2/1/89 (Interest payment)
8/1/89 (Interest payment)
12/31/89 (Adjusting)
1/1/90 (Reversing)
12/31/91 (Adjusting)
1/1/92 (Reversing)
2/1/92 Interest Expense 5,000
Cash 5,000
Bonds Payable 100,000
cash 100,000
(Bond Retirements at Maturity)

38
Accounting for Bonds Payable (Contd.)

Accounting for B/P when Bonds are issued at a
Discount
information of example 2 is summarized below
with
some additional information
Stated Interest 10 (annual)
Effective Interest 12 (annual)
Date if Issuance 1/1/87 (sold on 1/1/87)
Date of Maturity 1/1/92
Interest Payment Dates 1/30 and 12/31
Face Value 100,000
P.V. of the Bond 92,640.50 (as computed on p.20)

39
Accounting for Bonds Payable (Contd.)

Accounting for B/P when Bonds are issued at a
Discount
information of example 2 is summarized below
with
some additional information
Stated Interest 10 (annual)
Effective Interest 12 (annual)
Date if Issuance 1/1/87 (sold on 1/1/87)
Date of Maturity 1/1/92
Interest Payment Dates 1/30 and 12/31
Face Value 100,000
P.V. of the Bond 92,640.50 (as computed on p.20)

40
Accounting for Bonds Payable (Contd.)

Discount 100,000 - 92,640.5 7,359.50
This discount would increase the interest expense
and would be amortized over the life of the bond
95year, 10 periods)
Amortization methods
1. Straight-Line the Discount would be amortized
equally over the life of the bond.
i.e., Amortization for over period (6 months)
7349.50?10 735.95
Therefore, the interest expense for every period
is
5,000 7,359.5 5,735.95
Semiannual the amortized Discount
Interest Payment

41
Accounting for Bonds Payable (Contd.)

Total Interest expense
5,735.95 x 10 5,7359.5
50,000 7,359.5
Int. payment Discount
2. Effective - Interest Method
Interest Expense P.V. of Bond ? effective rate
(would be discussed later)

42
Accounting for Bonds Payable (Contd.)

J.E (Bonds are issued at Discount and using the
Straight-Line method to amortize the Discount)
1/1/87 Cash 92640.50
Discount on Bonds payable 7359.50
B/P 100,000
6/30/87 Interest Expense 5,736
Cash 5000
Discount on Bonds Payable 735.95
12/31/87 Interest Expense 5,736
Cash 5,000
Discount on Bonds Payable 735.95

43
Accounting for Bonds Payable (Contd.)

Interest Payment semiannual interest
100,000 x
10 x 1/2
Amortization of Discount over 10 periods
(7359.50/10)
Interest Expense Interest Payment Amortized
Discount.
6/30/88 Same J.E. as recorded on 6/30/87
12/31/88 Same J.E. as recorded on 6/30/87
6/30/89 Same J.E. as recorded on 6/30/87
12/31/89 Same J.E. as recorded on 6/30/87
6/30/90 Same J.E. as recorded on 6/30/87
12/31/90 Same J.E. as recorded on 6/30/87
6/30/91 Same J.E. as recorded on 6/30/87
12/31/91 Same J.E. as recorded on 6/30/87

44
Accounting for Bonds Payable (Contd.)

12/31/91 Interest Expense 5,736
Cash 5,000
Discount on Bonds Payable 735.95
1/1/91 B/P 100,000
Cash 100,000

45
Accounting for Bonds Payable (Contd.)

J.E. for Bonds issued at Discount and using
Effective Interest Method to amortize the
Discount (Required by FASB to use the Effective
interest Method if two amortization methods
generate significant different result.) using the
same example on p.32.
Semiannual Interest Payment 5,000
Interest Expense P.V. of Bond at the Beginning
of the period ? Effective Rate Amortized Discount
Interest Expense - Interest payment (cash
payment)

46
Accounting for Bonds Payable (Contd.)

Interest payment (cash payment)
Face x Stated Rate 100,000 x 10 x 1/2
5,000

47
Accounting for Bonds Payable (Contd.)

J.E (issued at Discount Effective interest
Amortization
method)
1/1/87 Cash 92,641
Discount on Bonds 7,359
B/P 100,000
6/30/87 Interest Expense 5,558
(period 1) Cash 5,000
Discount on Bonds Payable 558
12/31/87 Interest Expense 5,592
(period 2) Cash 5,000
Discount on Bonds Payable 592

48
Accounting for Bonds Payable (Contd.)

6/30/88 Interest Expense 5,672
Cash 5,000
Discount on Bonds Payable 672
6/30/91 Interest Expense 5,890
Cash 5,000
Discount on Bonds Payable 890
12/31/91 Interest Expense 5,944
Cash 5,000
Discount on Bonds Payable 944
1/1/91 B/P 100,000
Cash 100,000

49
Accounting for Bonds Payable (Contd.)
50
Accounting for Bonds Payable (Contd.)

APB Opinion 21 requires the use of the effective
interest method for the amortization of premiums
or discounts, unless the use of another method
producers results that are not materially
different from those obtained by the effective
interest method.
APB opinion 21 also requires the separate
recording of premium and discounts.
Any expenditures connected with a bond issue
(legal fee, printing costs, accounting ) should
be deferred and amortized as expanse over the
life of the bond using the straight-line method.

51
Accounting for Bonds Payable (Contd.)

Accounting for B/P when Bonds are issued at a
Premium
Information of example 3 is summarized with some
additional information.
Stated Interest Rate (annual) 10
Effective Interest Rate (annual) 8
Date of Issuance 1/1/87 (sold on 1/1/87)
Date of Maturity 1/1/91
Interest Payment Date 6/30 and 12/31
Face Value 100,000
P.V. of the Bond 108,115 (as computed on p.24)

52
Accounting for Bonds Payable (Contd.)

Premium 108,114.5 - 100,000 8,114.5
The premium would decrease the interest expense
and should be amortized over the life (5 years,
10 periods) of the bond.
J.E. (Amortization Method Straight-Line)
8,114.5 / 10 8114.5 gt 811.45 would be
amortized for every period. The interest expense
would be decreased by 816 every period.
1/1/87 Cash 108,114.5
B/P 100,000
Premium on Bonds Payable 8,114.5

53
Accounting for Bonds Payable (Contd.)

6/30/87 Premium on Bonds Payable 811.45
Interest Expense 4,188.55
Cash 5,000
12/31/87 Premium on Bonds Payable 811.45
Interest Expense 4,188.55
Cash 5,000
6/30/91 Premium on Bonds Payable 811.45
Interest Expense 4,188.55
Cash 5,000

54
Accounting for Bonds Payable (Contd.)

12/31/91 Premium on Bonds Payable 811.45
Interest Expense 4,188.55
Cash 5,000
1/1/91 B/P 100,000
Cash 100,000

55
Accounting for Bonds Payable (Contd.)

Issued at A Premium Effective Interest
Amortization Table Face 100,000, Effective
rate 8 (annual)

Interest Expense Cash payment - Amortized
premium 50,000 - 8114.5 41,885.5
Rounding Error of 7 (968-961 7)
56
Accounting for Bonds Payable (Contd.)

J.E 1/1/87 Cash 108,114.5
B/P 100,000
Premium on Bonds Payable 8114.5
6/30/87 Interest Expense 4,325
(Period 1) Premium on Bonds Payable 675
Cash 5,000
12/31/87 Interest Expense 4,298
(period 2) Premium on Bonds Payable 702
Cash 5,000
6/30/88
Period3

57
Accounting for Bonds Payable (Contd.)

(period 9)
6/30/91 Interest Expense 4,076
Premium B/P 920
Cash 5,000
12/31/91 Interest Expense 4,028
Premium on B/P 972
Cash 5,000
1/1/91 B/P 100,000
Cash 5,000
(Retirement of Bonds at Maturity)

58
Accounting for Bonds Payable (Contd.)
59
Bond Retirements Before Maturity

Use example 2 (issued at a Discount) Bond Retired
at the end of period 3 for 98,000
Discount on Bonds
7,359 558..Period 1
592..Period 2
627..Period 3
5,582
Unamortized at the end of period 3
BV of the Bond 100,000 - 5,582 94,418

60
Bond Retirements Before Maturity

B/P 100,000
Loss on Retirement of Bonds 3,582
Discount on Bonds Payable 5,582
Cash 98,000
an extraordinary item (FASB No. 4)

61
Bond Retirements Before Maturity

Use example 2, bond retired on 10/1/93 (half way
through the 4th period) at 97 plus accrued
interest of 2,500.
Discount on B/P
7,359 558
592 Amortized Dis. For period 4
627 (6 month)
3 months (6652)
bal. 5,249.5
9/30/93 Interest Expense 2,832.5
Interest Payable 2,500
Discount on B/P 323.5
Interest of period 4 (see p.48 Amort. Table)
5,665/2

62
Bond Retirements Before Maturity

10/1/93 B/P 100,000
Interest Payable 2,500
Extraordinary loss 2,244.5
Cash 99,500
Dis on B/P 5,249.5

63
Other Types of Debt Extinguishment

Defeasance of Debtthe debtor is legally released
from being the primary debtor of the debt either
by law or by the creditor (I.e., the affiliate a
gross to become the primary debtor for the debt).
Accounting treatment the liability is remove
from the B/S and reports an extraordinary gain.
In-substance defeasance the debtor place cash or
other assets in a inevitable trust to be used for
satisfying a specific debt.
If the trust satisfies the following conditions,
the FASB allows to remove the liability from the
B/S

64
Other Types of Debt Extinguishment(Contd.)

1.Trust is restricted to monetary assets that are
risk free to the amount, the timing and
collection of interest and principal.
2.The monetary assets must provide cash flows
that are similar to timing and amount to the
scheduled interest and principal payments on the
debt being extinguished.

65
Accounting for Bonds Between Interest Payment
Dates

Assume that on 2/1/87, Page company issued a 5
year term bond with a face amount of 100,000 and
a stated interest rate of 10. The bonds were
issued at Par (because the effective interest
rate is also at 10) and interests were paid
semiannually on 2/1 and 8/1. The bonds were sold
on 5/1/87.
Policy of interest payment for bonds
Interest are always paid in full (i.e., 6 months
if interest are paid semiannually) regardless how
long the bonds being held by the bondholder.
Therefore, the bond issuing company collects the
accrued interests in addition to the issuing
price when bonds are issued between interest
payment dates.

66
Accounting for Bonds Between Interest Payment
Dates

J.E. 5/1/87 (5 year bond issued at par on
5/1/87)
Cash 102,500
Bonds Payable 100,000
Interest Expense 2,500
Accrued interest of 3 months (From 2/1 5/1)
gt 100,000 x 10 x 3/12 2,500
8/1/87 Interest Expense 5,000
Cash 5,000
100,000 x 10 x 6/12 5,000 (6 month interest)
Actual Interest Expense (from 5/1/87 - 8/1/87)
gt
5,000 -2,500 2,500

67
Debt Issued at Premium or Discount And Sold
Between Interest Payment Date

Green Company issued a two-year, 8 term bonds
with a maturity value of 200,000. The bonds are
dated 1/1/92 and pay 8,000 interest
semiannually on 7/1 and 12/31. They are sold at
3/1/92 for 196,123, which includes 2,667
accrued interest from 1/1/92 to 3/1/92 to yield
5 interest semiannually. Issued price at 1/1/92
(P.V. on 1/1/92) gt
P.V. of the principle 200,000 x .8827 164,540
P.V. of Interest 8,000 x 3.5460 28,368
P.V. on 1/1/92 192,908

68
Debt Issued at Premium or Discount And Sold
Between Interest Payment Date (Contd.)

The P.V. of the bonds on 3/1/92 gt (P1V1 PV0
Dis. Amortized) in the period
192,908 1,645 x 2/6
192,908 548
193,456
Accrued interest (1/1/92 - 3/1/92)
200,000 x 4 x 2/62,667
Therefore, the selling price on 3/1/92 gt
193,456 2,667 196,123 (including the
accrued
interest)
See the schedule of Interest and B.V. on p.63

69
Debt Issued at Premium or Discount And Sold
Between Interest Payment Date (Contd.)

J.E. on 3/1/92
Cash 196,123
Dis. On B/P 6,544
B/P 200,000
Interest Payable 2,667
(200,000 - 193,456) or (200,000 - 192,908) -
548

70
Debt Issued at Premium or Discount And Sold
Between Interest Payment Date (Contd.)

Schedule of Interest B.V

192,908 x 0.05 9,645 in which 3215 (9645 x
6/5) was for the period of 1/1/92 - 3/1/92
9,645 - 8,000 1,645 in which 548 (1,645 x 2/6)
was for period of 1/1/92 - 3/1/92
71
Debt Issued at Premium or Discount And Sold
Between Interest Payment Date (Contd.)

7/1/92 Interest Expense 6,430
Interest Payable 2,667
Discount on B/P 1,097
Cash 8,000
1. 9,645 x 4/6 6,430
2. 1,645 x 4/6 1,097
12/31/92 Interest Expense 9,728
Cash 8,000
Discount on B/P 1,728

72
Debt Issued at Premium or Discount And Sold
Between Interest Payment Date (Contd.)

7/1/93Interest Expense 9,814
Cash 8,000
Discount 1,814
12/31/93 Interest Expense 9,905
Cash 8,000
Discount 1,905
Discount on B/P
6,544 1,097
1,728
1,814
1,905
0

73
Debt Issued at Premium or Discount And Sold
Between Interest Payment Dates

Green Company issued a two-year, 8 term bonds
with a maturity value of 200,000. The bonds are
dated 1/1/92, and pay 8,000 interest
semiannually (0.04 x 200,000) on 7/1/ and 12/31.
They are sold at 3/1/92 for 196,123, which
includes accrued interest 2,667 from 1/1/92 to
3/1/92 to yield 5 interest semiannually.

74
Debt Issued at Premium or Discount And Sold
Between Interest Payment Dates (contd.)

Issue price at 1/1/92 gt
PV of Principal200,000 x .8227 164,540
PV of Interest 8,000 x3.5460 28,368
192,908
Add Growth in bond value
(including accrued interest from
1/1/92 -3/1/92 at the effective rate)
192,908 x 5 x 2/6 3,215
Issue Price on 3/1/92 196,123

75
Debt Issued at Premium or Discount And Sold
Between Interest Payment Dates (contd.)

Issue Price on 3/1/92 (including
interest) 196,123
Less Accrued Interest (1/1/92 - 3/1/92)
200,000 x 4 x 2/6 (2,667)
Issue Price (Net of Accrued Interest) 193,456
Amortization of Discount (from 1/1/92 - 3/1/92)
gt 193,456 - 192, 908 548 (Effective Interest
Method) (or 3,215 -2,667 548)
3/1/92 Cash 196,123
Interest Payable 2,667
Bonds Payable 193,456

76
Debt Issued at Premium or Discount And Sold
Between Interest Payment Dates (contd.)

Or Cash 196,123
Discount on B/P 6,544
Interest Payable 2,667
B/P 200,000
Initial Discount (7,092 - 548) 6,544

77
Accruing Bond Interest

Assumed that Page Company issued a 5-year term
bond with a face amount of 100,000 and a stated
interest of 10 on 10/1/87. The bonds were sold
on 10/1/87 and interest were paid semiannually
(on 10/1 and 4/1). The effective interest rate is
12. Therefore, the present value of the bonds is
92,640.5
J.E 10/1/97 Cash 92,640.50
Discount 7,359.50
B/P 100,000

78
Accruing Bond Interest (contd.)

12/31/87 (adjusting entry for accrued interest
expense)
(Straight -line method)
Interest Expense 2,858
Interest Payable 2,500
Discount on B/P 368
7,359.50 / 5 x 3/12 368 (straight-line method)
12/31/87 (using the effective interest method)
Interest Expense 2,779
Interest Payable 2,500
Discount on B/P 279
Effective Interest of 3 months
92,640.50 x (12 x 1/2) x 3/6 2,779

79
Accruing Bond Interest (contd.)

Effective Interest Method
4/1/88 Interest Expense 2,779
Interest Payable 2,500
Cash 5,000
Discount on B/P 279
10/1/88 Interest Expense 5591.91
Cash 5,000
Discount on B/P 591.91

80
Bonds Issued with Detachable Stock Warrants
(Stock Rights)

Stock warrants represent rights that enable the
security holder to acquire a specific number of
common stock at a given price within a certain
time period. Stock warrants are attached to bonds
to increase their marketability (i.e., to result
in a lower interest rate or a greater proceeds
compared with other bond issues with similar risk
but without such warrants).

81
Bonds Issued with Detachable Stock Warrants
(Stock Rights) (contd.)

These detachable warrants will sell separately
from the bonds on the open market within a short
time of issue. APB Opinion 14 requires that a
pattern of the proceeds from bonds issued with
detachable warrant be allocated to the stock
warrants and accounted for as additional paid-in
capital. The allocation is based on the relative
market values of the bonds and warrants.

82
Example

Paul Company sold 800,000 of 12 bonds at 101
(or at 808,000). Each 1,000 bond carried 10
warrants, and each warrant allowed the holder to
acquire one share of 5 par common stock for 25
per share. After issuance, the bonds were quoted
at 99 ex rights (without the right attached and
the warrants were quoted at 3 each.

83
Example (contd.)

Value Assigned to Bonds
990 ? 800
---------------------------------------- ?
808,000
990 ? 800 (3 ? 800 ? 10)
784,235.29
Value Assigned to Warrants (right)
3 ? 800 ? 10
---------------------------------------- ?
808,000
990 ? 800 (3 ? 800 ? 10)
23,764.71

84
Example (contd.)

Bonds with same risk can only be issued at 99
(rather than 101) without warrants
J.E Cash 808,000
Discount on B/P 15,764.71
B/P 800,000
800,000 -784,235.29 15,764.71

85
Example (contd.)

23,764.71
Value of One Warrant ----------------- 2,971
10 ? 800
If 500 of the warrants were exercised at the 25
per share exercise price, the entry is
Cash 12,500 1
Common Stock Warrants 1,485.50 2
Common Stock 2,500 3
Additional Paid-in
Capital on C.S 11,485.50 4
1. 25 x 500 2. 2,971 x 500
3. 5 x 500 4. (12,500 1485.50)
- 2,500

86
Example (contd.)

If the remaining warrants expire, the following
entry would be made
Common Stock Warrants 22,279.21 1
Additional Paid-in Capital
From Expired Warrants 22,279.21
1. 23,764.71 -1,485.50

87
Convertible Bonds

Bonds that may be converted into common stock. At
Conversion, the bond holder exchanges the bonds
for a specific number of common shares. Reasons
of issuing convertible bonds

88
Convertible Bonds (contd.)

1. The company eventually wants to increase its
equity
2. The company wants to increase its debt and the
conversion feature is necessary to make the
security marketable at a reasonable interest
rate
3. Avoid the downward price pressure on its
stock
4. Avoid the direct sale of its stock when it
believes its stock currently is undervalue.

89
Accounting Treatment

APB Opinion 14 requires that the issuance of
convertible debt is recorded in the same manner
as the issuance of nonconvertible debts without
allocating a value (from the proceeds received)
to the conversion feature.

90
Recording for the Conversion

Two acceptable methods
A. Book Value Method the stockholders equity is
recorded at the book value of the convertible
bonds on the date of conversion.
No gain or loss is recorded upon conversion.
If the par value of the common stock is greater
than the book value of the bonds, the difference
is recorded as a reduction of retained earnings.

91
Recording for the Conversion (contd.)

B. Market Value Method The stockholders equity
is recorded at the market value of the shares
issued on the date of conversion, and a gain or
loss is recorded (treated as an ordinary income
or loss).
The gain or loss is the difference between the
market value of the converted common stock and
the book value of the bonds.
IF the conversion occurs between interest dates,
the interest expense needs to be recorded and
amortization of discount or premium also needs to
be recognized to update the book value of the
bonds.

92
Example

Shannon Company has outstanding convertible bonds
with a face value of 10,000, interest has been
paid on these bonds, and the bonds have a book
value of 10,500. Each 1,000 bond is convertible
into 40 shares of common stock (par value 20 per
share). If all the bonds are converted into
common stock when the market value of shannons
common stock is 26.5 per share, the following
alternative entries may be made

93
Example (contd.)

A. Book Value Method (BV of the bonds 10,500)
(more commonly used by company)
Bonds payable 10,000
Premium Bonds Payable 500
Common Stock 1 8,000
Paid-in Capital from
Bond Conversion 2 2,500
1. 20 x 40 x 10
2. 10,500 - 8,000

94
Example (contd.)

B. Market Value Method (MV of converted Stock
26.5 x (40x 10) 10,600)
Bonds payable 10,000
Premium on B/P 500
Loss on Conversion 100
Common Stock 8,000
Paid-in Capital from
Bond Conversion 2,600 1
1. 10,600 - 8,000

95
Induced Conversions

A Company may sweeten the conversion feature
(i.e., increase the converted shares from 40
shares to 50 share for every 1,000 bonds) to
induce the conversion of bonds to common stock in
order to reduce interest costs. The additional
cost (i.e., the fair value of the additional 10
shares on the date the inducement offer is
accepted by the convertible bondholder) is
recognized as an expense.

96
Example

Harmon Company had issued convertible bonds at
par.The conversion terms allowed each 1,000 bond
to be converted into 40 shares of common stock
(par value 21 per share). To induce the
conversion terms to 50 shares if conversion is
made in 60 days. All the bonds were converted
within the time limit when the market price of
the common stock is 30 per share. Using the book
value method, the following entry will be rcorded

97
Example (contd.)

Bonds Payable 10,000
Bond Conversion Expense 3,000
Common Stock
( 21 x 50 x 10) 10,500
Paid-in Capital in Excess
of Par Value 2,500

98
Example (contd.)

If the market value method is used, the following
entry will be recorded
B/P 10,000
Bond Conversion Expense 3,000
Loss on Conversion 2,000
Common Stock (21 x 50 x 10) 10,500
Paid-in capital in Excess of Par 4,500

99
Long-Term Notes Payable

APB Opinion No. 21 requires the long-term notes
payable to be recorded at their present values
and the effective interest method is used to
record the subsequent interest. The effective
interest rate (or implicit rate) is the rate that
equates the future net cash flows to the present
value. Therefore, if the present value and future
net cash flows are known, the effective interest
can be calculated.

100
Long-Term Notes Payable (contd.)

Also, if both the effective interest rate and
future net cash flows are known, the Present
Value (P.V.) can be calculated.
In cases when the P.V. of a note payable and the
future cash flows (i.e., the maturity value and
interest) are known, the effective interest rate
can then be derived.

101
Long-Term Notes Payable (contd.)

In other cases, when the P.V. is net known, the
incremental interest rate of the borrower (the
rate the borrower would be required to pay to
obtain similar financing in the credit market at
the time the note is issued) is used as the
effective rate to calculate the P.V. of the note.

102
Long-Term Notes Payable (contd.)

A. Notes Payable issued for cash when a long-term
note is exchanged for cash, the note is assumed
to have a present value equal to the cash
proceeds. The difference between the cash
proceeds and the face value of the note is
recorded as a discount (or premium) and amortized
over the life of the note by the effective
interest method.

103
Example

Johnson Company issued a 3-year,
non-interest-bearing note with a face value of
8,000 and received 5,694.24 in exchange. The
journal entry to record the issuance is
Cash 5,694.24
Discount on
Notes Payable 2,305.76
Note Payable 8,000

104
Example (contd.)

The discount account is a contra account to notes
payable. The effective interest rate that equates
the P.V. of 5,694.24 to 8,000 at the end of 3
years is 12.
5,694.24 8,000 x 0.71178 ? 3-period, 12

105
Example (contd.)

The Interest Expense per Year is Computed as

106
Example (contd.)

Recognition of Interest Expense of Year 1
Interest Expense 683.31
Discount on N/P 683.31
Cash
(non-interest bearing note) 0

107
Notes Payable Exchanged for Cash AND Rights or
Privileges

A company might sign a contract with a customer
in which the company borrows cash from the
customer on a non-interest-bearing basis, with
the understanding that the customer has the right
to purchase certain goods from the company at
less that prevailing price over the period of the
contract.

108
Example

Verna Company borrows 100,000 by issuing a
3-year, non-interest-bearing note to a customer.
Verna agrees to sell inventory to a customer at
reduced prices over a 5-year period. Vernas
incremental borrowing rate is 12 so that the
P.V. of 100,000 to be repaid at the end of 3
years is 71,178. The customer agrees to purchase
an equal amount of inventory each year over the
5-year period so that a straight line method of
revenue recognition is appropriate. The following
entries are recorded during the first two years

109
Example (contd.)

Issuing the Note
Cash 100,000
Discount on N/P 28,822
N/P 100,000
Unearned revenue 28,822

110
Example (contd.)

End of first Year
Interest Exp. (71,178 x 12) 8,541.36
Discount on N/P 8,541.36
Unearned Revenue (28,822/5) 5,764.40
Sales Revenue 5,764.40
End of Second Year
Interest Exp.
(76,178 8,541.36) x 12 9,566.32
Discount on N/P 9,564.40
Unearned Revenue 5,764.40
Sales Revenue 5,764.40

111
Notes Payable Exchanged for Cash AND Rights or
Privileges (contd.)

Therefore, the accounting treatment are
1. The note is recorded at the P.V. of the note
at the time of issuance
2. The difference between the cash proceeds
(i.e., 100,000) and the P.V. of the note is
recorded as unearned revenue (100,000 -71,178),
and revenue is recognized over the life of the
contract using appropriated revenue recognition
method.
3. The discount of the note is amortized over the
life of the note using the effective interest
method.

112
Notes Payable Exchanged for Property, Goods, or
Services

APB opinion No.21 requires the note be recorded
at the fair market value of the property, goods,
or services or the fair market value of the note
(I.e., the present value of the note if known),
whichever is more reliable. And, the effective
interest rate is calculated (when both the P.V.
and future cash flows are known) and used to
calculate subsequent interest expense using the
effective interest method.

113
Notes Payable Exchanged for Property, Goods, or
Services (contd.)

If neither of these values is determinable, the
incremental borrowing rate of the borrower is
used as the effective interest rate to calculate
the P.V. of the Note and the interest expense of
subsequent years using the effective interest
method.

114
Example

On 1/1/95, Marden Company purchases an equipment
by issuing a non-interest-bearing 5-year note
with a face value of 10,000. Neither the fair
market value of the equipment nor that of the
note is determinable. The incremental borrowing
rate of Marden is 12.

115
Example (contd.)

J.E. 1/1/95
Equipment 5,674.27
Discount on N/P 4,325.73
N/P 10,000
P.V. of the note using 12 as the effective
interest rate gt 10,000 x 0.567427

116
Example (contd.)

12/31/95
Int. Exp. (5674.27 x 12) 680.91
Discount on N/P 680.91
Depreciation Expense 567.43
Accumulated Depreciation 567.43
(Assuming a S-L Depreciation method is used and a
10-year life is assumed for the equipment)

117
Example (contd.)

12/31/96
Int. Exp. (5,674.27 680.91) x 12 762,62
Discount on N/P 762.62
Depreciation Expense 567.43
Accumulated Depreciation 567.43

118

Using the previous example, except that the fair
market value the equipment was determined at
6,209.21. The interest rate that equates the
future cash flows to the present value of
6,209.21 is 10. The following entries would be
recorded for 1995 and 1996

119

1/1/95
Equipment 6,209.21
Discount on N/P 3,790.89
N/P 10,000
12/31/95
Int. Exp. (6,209.21 x 10) 621
Discount on N/P 621
12/31/96
Int. Exp. (6,209.21 621) x 10 683
Discount on N/P 683

120
Long-term Notes Receivable

If a long-term note received from selling
property, goods, providing service, the note is
recorded at the fair market value of the property
goods, or services or the fair market value of
the note (the present value if known), whichever
is more reliable. An effective interest rate will
then be derived and used to amortized the
discounts or premiums.

121
Long-term Notes Receivable (contd.)

If neither of these values is reliable, the note
is recorded at its present value by using the
borrowers incremental interest rate (as the
effective interest rate). The effective interest
method is used to record subsequent interest
revenue.

122
Example

Joyce Company accepted a 10,000,
non-interest-bearing, 5 year note on 1/1/95 in
exchange for an equipment sold to Marden Company.
Since a reliable fair market value of the
equipment or the note was not available, Mardens
(the borrower) 12 incremental borrowing rate was
used to determine a P.V. of 5,674.27 for the
note. The lose of the equipment is 8,000 and the
book value is 5,000 on the date of sale. The
following entries will be recorded for Joyce

123
Example (contd.)

1/1/95
Notes Receivable 10,000
Accumulated Depreciation 3,000 2
Discount on N/R 1 4,325.73
Equipment 8,000
Gain on Sale of Equipment 3 674.27
1. 100,000 -5,674.27
2. 8,000 - 5,000 (B.V.)
3. P.V. of the Note - B.V. of the Equipment
5,674.27 - 5,000

124
Example (contd.)

12/31/95
Discount on N/R 1 680.91
Interest Revenue 680.91
1. 5,674.27 x 12
P.V. of Note on 1/1/95

12/31/96 Discount on N/R 1 762.62 Interest
Revenue 762.62 1. (5,674.27 680.92) x 12
125
Impairment of Loan (FASB 114)

A loan note receivable is impaired if it is
probable that the creditor will be unable to
collect all amounts due according to the
(contractual) terms of the loan agreement. When a
loan is found to be impaired, the creditor
company (often a financial institution) computes
the present value of the expected future cash
flows of the impaired loan using the original
effective interest rate on the loan. The amount
by which the present value is less than the
recorded investment in the loan is recognized as
Bad Debt Expense and Allowance for Doubtful Notes.

126
Installment Notes

Notes could be paid by installments (a constant
amount paid periodically) rather than by a single
amount at maturity. Using the above example on
page 124, assuming an installment payment at the
end of each year for the following 5 years, (
starting 12/31/95), the annual installment
payment for the note (loan) equals
6,209.21? 3.790791,638

127
Installment Notes (Contd.)

Journal Entries
1/1/95 Equipment 6,209.21 Note
Payable 6,209.21
12/31/95 Interest Exp. 621 N/P
1,017 Cash 1,638 6,209.21 x 10 621
12/31/96 Interest Exp. 519 N/P
1,119 Cash 1,638 (6,209.21 - 1,017) x
10 519.2

128
Installment Notes (Contd.)

Journal Entries
12/31/97 Interest Exp. 407 N/P
1,231 Cash 1,638 (16,209-1,017-1,119)
x 10 407
12/31/98 Interest Exp. 284 N/P
1,354 Cash 1,638 (16,209-1,017-1,119-1,
231) x 10 284
12/31/99 Interest Exp. 149 N/P
1,489 Cash 1,638 (16,209-1,017-1,119-1,2
31- 1,354) x 10 149

129
Installment Notes (Contd.)
130
Example

Assuming Snook Company has a note receivable of
100,000 from the Ullman Company that is being
carried at face value. The loan agreement
specifies that interest of 8 is payable each
12/31 and the principal is to be paid on
12/31/2000. The Ullman paid the interest due on
12/31/95, but informed the Snook Company that it
probably would have to miss the next two years
interest payments. After that, it expected to
resume the 8,000 annual interest payments, but
the principal payment would be made one year late
with interest paid for the additional year. The
present value P.V. of the impaired loan of Snook
on 12/31/95 is

131
Example (contd.)