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Chapter 14

Chapter 14. Intermediate Accounting II Otto Chang Professor of Accounting. 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

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Chapter 14

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  1. Chapter 14 Intermediate Accounting II Otto Chang Professor of Accounting Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  5. Effective Interest Method Example: 10% 5-yr $10,000 bonds sold at $108,530 to yield 6% Cash Interest Premium Carrying Date Paid ExpenseAmortizedValue 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 Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  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 Chang, Otto

  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 • C’s 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 • FASB’s requirement: footnote disclosure Chang, Otto

  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 Chang, Otto

  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-bearing 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, FMV=$16,000) 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 • Debtor’s 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*) > $10,500,000 *2,880,000 = $9,000,000 x 8% x 4 Chang, Otto

  20. Debtor’s 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 Chang, Otto

  21. Creditor’s 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% Chang, Otto

  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*) < $10,500,000 by $1,260,000 *2,240,000 = 7,000,000 x 8% x 4 Chang, Otto

  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 Chang, Otto

  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% Chang, Otto

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