I.

Nature of Long-Term Debt

A. Liabilities signify creditors’ interest in a company’s assets.
B. Debt requires the future payment of cash in specified (or estimated) amounts, at specified (or
projected) dates.
C. As time passes, interest accrues on debt.
D. Periodic interest is the effective interest rate times the amount of the debt outstanding during the
interest period.
E. As the time value of money is likely to be material, it is reported at the present value of its related
cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance.

Part A: Bonds
I. Bonds
A. Divide a large liability into many smaller liabilities (usually $1,000 per bond).
B. Obligate a company to repay a stated amount at a specified maturity date and periodic interest
between the issue date and maturity.
C. Require periodic interest as a stated percentage of the principal amount.
D. Pay interest semiannually (usually) on designated interest dates beginning six months after the day
the bonds are “dated.”
E. Make specific promises to bondholders who are described in a document called a bond indenture.
F. Represent a liability to the company that issues the bonds and an asset to a company that buys the
bonds as an investment.
Issuer
Cash .................................................................................... xxx
Bonds payable (principal amount)............................. xxx

Investor
Investment in bonds (principal amount)............................. xxx
Cash............................................................................ xxx

II. Recording Bonds at Issuance

A. Supply and demand causes a bond to be priced to yield the market rate of interest for securities of
similar risk and maturity.
1. Price can be calculated as the present value of all the cash flows required (principal and interest).
2. The discount rate is the market rate at inception.
B. Other things being equal, the lower the perceived riskiness of the company issuing bonds, the higher
the price those bonds will command.
C. When bond prices are quoted in financial media, they typically are stated in terms of a percentage of
face amount or principal. So, a price quote of 98 means a $1,000 bond will sell for $980; a bond
priced at 101 will sell for $1,010.

III. Determining Interest—Effective Interest Method

A. Interest accrues at the effective interest rate, which exactly discounts the expected future cash flows
to the initial net carrying amount of the debt.
1. The effective interest rate is usually close to the market interest rate on a similar instrument, with
similar risk characteristics, on the date of issue.
2. The effective interest rate may be different from the cash interest rate.
B. Interest expense is the effective interest rate multiplied by the outstanding balance of the debt at the
beginning of the period.
 C. When only a portion of an expense is paid by the periodic cash interest payment, the remainder
becomes a liability (or an addition to the already outstanding liability). So the difference increases the
liability and is reflected as a reduction in the discount (a valuation or contra account).
D. Because the balance of the debt changes each period, the dollar amount of interest outstanding
(balance  rate) also will change each period. To keep up with the changing amounts, it usually is
convenient to prepare a schedule that reflects the changes in the debt over its term to maturity.
E. If an accounting period ends between interest dates, it is necessary to record interest that has accrued
since the last interest date.
F. Do note that determining interest by allocating the discount (or premium) on a straight-line basis is
not permitted under IFRS, although it is allowed under US GAAP.

IV. Zero Coupon Bonds

A. A zero coupon bond pays no interest but, instead, offers a return in the form of a “deep discount” from
the principal amount.
B. In some countries, these bonds are attractive to investors as tax is not paid on the zero cash coupons

V. Debt Transaction Costs

A. According to IFRS 9, transaction costs include fees and commissions paid to advisers and
intermediaries, payment of levies to regulatory agencies and stock exchanges, and specific types of
taxes paid to governments.
1. Debt premiums or discounts, financing costs or an entity’s administrative or holding costs are not
transaction costs.
B. Debt transaction costs are recognized as yield adjustments to the effective interest rate.
1. The costs are typically kept on the statement of financial position in a contra/linked account to
the debt account.
a. The maintaining of a contra account is not a requirement but its presence helps the company
to keep track of the balance yet to be amortized.
2. As the costs reduce the net proceeds from the debt issue, they increase the effective borrowing
rate.
3. Not all transaction costs qualify for yield adjustments; for example, service fees incurred
periodically to maintain, but not originate, the loan are expensed off immediately.
C. The transaction cost is amortized to expense over the term to maturity.
1. Transaction costs that are an integral part of the effective interest rate are amortized, together
with premiums or discounts, over the expected life of the debt or the period in which the benefits
relating to the cost are realized, whichever is shorter.

VI. Option to Report Liabilities at Fair Value

A. Financial liabilities that are held-for-trading must be measured at fair value at the end of each
reporting period.
B. A company is not required to, but has the option to measure, non-trading financial assets and
liabilities, including bonds and notes, at fair value if any of the following conditions exist.
1. An accounting mismatch exists between financial assets and financial liabilities.
2. Management of financial assets and liabilities requires the use of fair value information.
3. Note that US GAAP is less restrictive than IFRS and permits the issuer to apply the fair value
option unconditionally.
4. Also note that, it’s not necessary that the company elect the option to report all of its financial
instruments at fair value or even all instruments of a particular type at fair value.
C. If a company chooses the option to report at fair value, a change in fair value will create a gain or
loss. Any portion of that gain or loss that is a result of a change in the “credit risk” of the debt, rather
than a change in general interest rates, is reported, not as part of net income but instead as other
comprehensive income (OCI).
 1. Companies can assume that any change in fair value that exceeds the amount caused by a change
in the general (risk-free) interest rate is the result of credit risk changes.

Part B: Long-Term Notes

A. In substance, notes are accounted for in precisely the same way as bonds.
I. Notes Issued B. The interest rate stated in a note is likely to be equal to the market rate
for Cash because the rate usually is negotiated at the time of the loan. So discounts and
premiums are less likely for notes than for bonds.
A. When a note is issued with an unrealistic interest rate, the effective market
II. Notes rate is used both to determine the amount recorded in the transaction and to
Exchanged for Assets record periodic interest thereafter.
or Services 1. Substance over form principle must be applied.
2. Accounting treatment is the same whether the amount is determined
directly from the market value of the asset acquired (and thus the note, also) or indirectly as the
present value of the note (and thus the value of the asset).
3. Also, both parties to the transaction should record periodic interest (interest expense to the
borrower, interest revenue to the lender) at the effective rate, rather than the stated rate.

III. Installment A. Installment notes are paid in installments, rather than by a single amount at
Notes maturity.
1. Installment payments are equal amounts each period.
2. Each payment includes both an amount that represents interest and an amount that represents a
reduction of principal.
3. The periodic reduction of principal is sufficient that, at maturity, the note is completely paid.
4. The installment amount is easily calculated by dividing the amount of the loan by the appropriate
discount factor for the present value of an annuity.

IV. Financial A. On the statement of financial position, disclosure should include, for all long-
Statement Disclosures term borrowings, the aggregate amounts maturing and sinking fund
requirements (if any) in time bands for the remaining contractual period.
B. Supplemental disclosures are needed for:
1. off-balance-sheet credit or market risk,
2. concentrations of credit risk, and
3. the fair value of financial instruments.

Decision Makers’ Perspective

A. Failure to properly consider risk in business decisions is one of the most costly, yet one of the most
common, mistakes investors and creditors can make.
B. Long-term debt is one of the first places decision makers should look when trying to get a handle on
risk.
C. Generally speaking, debt increases risk.
1. The debt to equity ratio, total liabilities/shareholders’ equity, often is calculated to measure the
degree of risk.
2. Other things being equal, the higher the debt to equity ratio, the higher the risk.
D. Debt also can be an advantage by enhancing the return to shareholders.
1. This concept is known as leverage.
2. “Favorable financial leverage” occurs when a company earns a return on borrowed funds in excess
of the cost of borrowing the funds, shareholders are provided with a total return greater than what
could have been earned with equity funds alone.
E. Failure to pay interest as scheduled may cause several adverse consequences including bankruptcy.
 1. One way to measure a company's ability to pay its obligations is by comparing interest payments
with income available to pay those charges.
2. The times interest earned ratio is determined by dividing income before subtracting interest
expense or income tax expense by interest expense.
F. “Off-balance-sheet” financing and other commitments can increase risk.

Part C: Debt Retired Early, Convertible into Shares, or Providing an Option to Buy
Shares
I. Early Extinguishment of Debt
A. A gain or loss on early extinguishment of debt should be recorded for the difference between the
reacquisition price and the carrying amount of the debt.

II. Convertible Bonds

A. Convertible bonds are accounted for as both debt and equity.
1. Based on the “substance over form” principle, a convertible bond is no different from a pure
bond issued at market interest rate and a detachable warrant or stand-alone call option on the
issuer’s shares.
2. The debt and equity components are “bifurcated” even though each is a nondetachable
component in a hybrid instrument.
3. The effective interest rate of the convertible bond is the market interest rate of a pure bond of
similar credit risk characteristics.
4. Under US GAAP, convertible bonds are recorded as a straight debt.
B. Accounting for convertible bonds at issuance.
1. The entire issue price of the convertible bonds is split between debt and equity, which are
recorded separately (i.e., amortization of the bond).
C. If and when the bondholder exercises his or her option to convert the bonds into shares
1. The bonds and the equity options are removed from the accounting records.
2. New shares are issued and are recorded at the amount equal to the book value of the bonds and
the book value of the equity options.
3. The fair value method, which records the new shares at the fair value of the shares themselves or
of the bonds, whichever is more determinable, is not permitted under IAS No. 32.
D. Both the debt and equity components in a convertible bond have to be removed in an early
extinguishment of the instrument.
1. The loss on extinguishment of a convertible debt has to be allocated to the debt and equity
components using a process similar to that of allocating the initial proceeds on issue date.
2. The loss attributable to the debt component is taken to the income statement, while the loss
attributable to the equity component remains in equity (although it may be reclassified from
equity options to another component in equity).
3. The loss on equity is not taken to the income statement as the loss relates to transactions with
owners in their capacity as owners.
E. For induced conversion, any additional consideration provided to induce conversion of convertible
debt is recorded as an expense of the period. This includes:
1. fair value of any awards and
2. the difference between the fair value of the consideration received by the holder under the
revised terms and those under the original terms, for any modification of the terms of conversion.

III. Bonds With Detachable Warrants

A. The issue price of bonds with detachable warrants is allocated between the two different securities on
the basis of their market values.
 IV. United States Generally Accepted Accounting Principles

A. Differences in the definitions and requirements under these standards can result in the same
instrument being classified differently between debt and equity under IFRS and US GAAP. More
preferred stock (preference shares) is reported as debt under IFRS than US GAAP.
B. Under IFRS, convertible debt is divided into its liability and equity elements. Under US GAAP, the
entire issue price is recorded as debt.

Appendix A: Bonds Issued Between Interest Dates

A. All bonds sell at their price plus any interest that has accrued since the last interest date.

B. principal annual fraction of the accrued

value  rate  annual period = interest

Appendix B: Debt Restructuring

A. The way a debt restructuring is recorded depends on whether
1. The debt is settled at the time of the restructuring, or
2. The debt is continued, but with modified terms where
a. The terms of the loan are substantially modified or
1. Remove the carrying amount of the original debt from the statement of financial position
and recognize the restructured debt as if it is a new debt.
2. Under IFRS 9, the terms are “substantially different” if the present value of the
(remaining) cash flows from the revised and original terms, discounted at the original
effective interest rate, exceeds 10%.
b. The terms of the loan are not substantially modified.
1. Restructured debt will be deemed as a continuation of the original debt.
2. The changes in the contractual cash flows adjust the carrying amount of the loan but not
the effective interest rate.
3. Determine the new fair value of the existing loan and recognize a one-time gain/loss if
required.