1.kieso 2020-1118-1183

CHAPTER 14
Non-Current Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the nature of bonds and indicate the accounting for bond issuances.
2. Explain the accounting for long-term notes payable.
3. Explain the accounting for the extinguishment of non-current liabilities.
4. Indicate how to present and analyze non-current liabilities.
This chapter also includes numerous conceptual discussions that are integral to the
topics presented here.
PREVIEW OF CHAPTER 14
As the following opening story indicates, governments and companies are increasingly relying on
long-term borrowing to get the resources needed for operations. In this chapter, we explain the
accounting issues related to non-current liabilities. The content and organization of the chapter
are as follows.
Going Long
Governments issue debt when their expenditures exceed their tax receipts. This is often the case when
governments want to stimulate their economies either directly via spending or indirectly through a
reduction in taxes. While this is a reasonable policy, many governments have in practice operated at
substantial deficits for a number of years, relying on borrowing to support their spending.
Consider chart (a), which shows the $69 trillion total government debt as of 2019. The size of each
country’s area in the chart reflects its portion of total government debt. Note that the United States
and Japan have the largest amount of outstanding debt; however, Japan’s debt to GDP ratio is over
two times that of the United States.
In addition to government debt, low interest rates and rising inows into bond funds have triggered
record bond issuances. As can been seen in chart (b), total debt outstanding has recently increased in
every region of the world. For example, total debt outstanding has increased from $4.3 trillion in 2007
to $11.7 trillion in 2017—an over 270 percent increase in 10 years.
Companies such as PayPal (USA), Air Liquide (FRA), and Toyota Motor (JPN) have all sold long-
term bonds recently. Increases in the issuance of these bonds suggest companies have a strong
appetite for issuing the bonds because they provide substantial cash infusion at a relatively low
interest rate. The hope is that the trend will prove beneficial for both the investor and the company in
the long run.
Review and Practice

Go to the Review and Practice section at the end of the chapter for a targeted summary review
and practice problem with solution. Multiple-choice questions with annotated solutions, as well
as additional exercises and practice problem with solutions, are also available online.
Bonds Payable
LEARNING OBJECTIVE 1
Describe the nature of bonds and indicate the accounting for bond issuances.
Non-current liabilities (sometimes referred to as long-term debt) consist of an expected outflow of

resources arising from present obligations that are not payable within a year or the operating cycle of
the company, whichever is longer. Bonds payable, long-term notes payable, mortgages payable,
pension liabilities, and lease liabilities are examples of non-current liabilities.
A company usually requires approval by the board of directors and the shareholders before bonds or
notes can be issued. The same holds true for other types of long-term debt arrangements.
Generally, long-term debt has various covenants or restrictions that protect both lenders and
borrowers. The indenture or agreement often includes the amounts authorized to be issued, interest
rate, due date(s), call provisions, property pledged as security, sinking fund requirements, working
capital and dividend restrictions, and limitations concerning the assumption of additional debt.
Companies should describe these features in the body of the financial statements or the notes, if
important for a complete understanding of the financial position and the results of operations.
Although it would seem that these covenants provide adequate protection to the long-term debtholder,
many bondholders suffer considerable losses when companies add more debt to the capital structure.
Consider what can happen to bondholders in leveraged buyouts (LBOs), which are usually led by
management. In an LBO of RJR Nabisco (USA), for example, solidly rated 93⁄8 percent bonds
plunged 20 percent in value when management announced the leveraged buyout. Such a loss in value
occurs because the additional debt added to the capital structure increases the likelihood of default.
Although covenants protect bondholders, they can still suffer losses when debt levels get too high.
Types of Bonds
We define some of the more common types of bonds found in practice as follows.
Types of Bonds
Secured and Unsecured Bonds. Secured bonds are backed by a pledge of some sort of
collateral. Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are
secured by shares and bonds of other companies. Bonds not backed by collateral are unsecured.
A debenture bond is unsecured. A “junk bond” is unsecured and also very risky, and therefore
pays a high interest rate. Companies often use these bonds to finance leveraged buyouts.
Term, Serial Bonds, and Callable Bonds. Bond issues that mature on a single date are
called term bonds; issues that mature in installments are called serial bonds. Serially
maturing bonds are frequently used by school or sanitation districts, municipalities, or other
local taxing bodies that receive money through a special levy. Callable bonds give the issuer the
right to call and retire the bonds prior to maturity.
Convertible Bonds. If bonds are convertible into other securities of the company for a
specified time after issuance, they are convertible bonds.
Two types of bonds have been developed in an attempt to attract capital in a tight money market
—commodity-backed bonds and deep-discount bonds. Commodity-backed bonds (also called
asset-linked bonds) are redeemable in measures of a commodity, such as barrels of oil, tons of
coal, or ounces of rare metal. To illustrate, Sunshine Mining (USA), a silver-mining company,
sold bonds that were redeemable with either $1,000 in cash or 50 ounces of silver, whichever
was greater at maturity, and that had a stated interest rate of 8½ percent. The accounting
problem was one of projecting the maturity value, especially since silver has fluctuated between
$4 and $40 an ounce since issuance.
Deep-discount bonds, also referred to as zero-interest debenture bonds, are sold at a
discount that provides the buyer’s total interest payoff at maturity, with no periodic interest
payments.
Registered and Bearer (Coupon) Bonds. Bonds issued in the name of the owner are
registered bonds and require surrender of the certificate and issuance of a new certificate to
complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner
and may be transferred from one owner to another by mere delivery.
Income and Revenue Bonds. Income bonds pay no interest unless the issuing company is
profitable. Revenue bonds, so called because the interest on them is paid from specified
revenue sources, are most frequently issued by airports, school districts, counties, toll-road
authorities, and governmental bodies.
Issuing Bonds
A bond arises from a contract known as a bond indenture. A bond represents a promise to pay (1) a
sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on the
maturity amount (face value). Individual bonds are evidenced by a paper certificate and typically have
a €1,000 face value. Companies usually make bond interest payments semiannually, although the
interest rate is generally expressed as an annual rate. The main purpose of bonds is to borrow for the
long term when the amount of capital needed is too large for one lender to supply. By issuing bonds in
€100, €1,000, or €10,000 denominations, a company can divide a large amount of long-term
indebtedness into many small investing units, thus enabling more than one lender to participate in
the loan.
A company may sell an entire bond issue to an investment bank, which acts as a selling agent in the
process of marketing the bonds. In such arrangements, investment banks could underwrite the entire
issue by guaranteeing a certain sum to the company, thus taking the risk of selling the bonds for
whatever price they can get (firm underwriting). Or, the underwriters could sell the bond issue for a
commission on the proceeds of the sale (best-efforts underwriting). Alternatively, the issuing
company could sell the bonds directly to a large institution, financial or otherwise, without the aid of
an underwriter (private placement).
What Do the Numbers Mean?

All About Bonds
How do investors monitor their bond investments? One way is to review the bond listings found
in the newspaper or online. Company bond listings show the coupon (interest) rate, maturity
date, and last price. However, because company bonds are more actively traded by large
institutional investors, the listings also indicate the current yield. Company bond listings would
look as follows.
Issuer Coupon Maturity Price Yield Rating
Vodafone Group 6.15% 2/17/2037 128.81 3.89% BBB
Telecom Italia S.p.A 7.20% 7/18/2036 116.24 5.65% BB+
The companies issuing the bonds are listed in the first column, in this case, two
telecommunications companies, Vodafone Group (GBR) and Telecom Italia S.p.A (ITA). In
the second column is the interest rate paid by the bond as a percentage of its par value, followed
by its maturity date. The Vodafone bonds, for example, pay 6.15 percent and mature on February
17, 2037. The Telecom Italia bonds pay 7.20 percent. The Vodafone bonds have a current yield of
3.89 percent, based on the price of 128.81 per £1,000. In contrast, the Telecom Italia bonds
selling at 116.24 yield 5.65 percent. The final column gives the bond rating. Vodafone, with a
rating of BBB, is viewed as more creditworthy than Telecom Italia, which explains why
Vodafone’s bonds sell at a higher price and lower yield.
Also, as indicated in the chapter, interest rates and the bond’s term to maturity have a real effect
on bond prices. For example, an increase in interest rates will lead to a decline in bond values.
Similarly, a decrease in interest rates will lead to a rise in bond values. The following data, based
on three different bond funds, demonstrate these relationships between interest rate changes
and bond values.
Bond Price Changes in 1% Interest 1% Interest
Response to Interest Rate Rate
Rate Changes Increase Decrease
Short-term fund (2–5 years) −2.5% +2.5%
Intermediate-term fund (5 years) −5% +5%
Long-term fund (10 years) −10% +10%
Source: The Vanguard Group.
Another factor that affects bond prices is the call feature, which decreases the value of the bond.
Investors must be rewarded for the risk that the issuer will call the bond if interest rates decline,
which would force the investor to reinvest at lower rates.
Valuation and Accounting for Bonds Payable

The issuance and marketing of bonds to the public does not happen overnight. It usually takes weeks
or even months. First, the issuing company must arrange for underwriters which will help market and
sell the bonds. Then, it must obtain regulatory approval of the bond issue, undergo audits, and issue a
prospectus (a document that describes the features of the bond and related financial information).
Finally, the company must generally have the bond certificates printed. Frequently, the issuing
company establishes the terms of a bond indenture well in advance of the sale of the bonds. Between
the time the company sets these terms and the time it issues the bonds, the market conditions and the
financial position of the issuing company may change significantly. Such changes affect the
marketability of the bonds and thus their selling price.
The selling price of a bond issue is set by the supply and demand of buyers and sellers, relative risk,
market conditions, and the state of the economy. The investment community values a bond at the
present value of its expected future cash flows, which consist of (1) interest and (2) principal.
The rate used to compute the present value of these cash flows is the interest rate that provides an
acceptable return on an investment commensurate with the issuer’s risk characteristics.
The interest rate written in the terms of the bond indenture (and often printed on the bond certificate)
is known as the stated, coupon, or nominal rate. The issuer of the bonds sets this rate. The stated
rate is expressed as a percentage of the face value of the bonds (also called the par value, principal
amount, or maturity value).
Bonds Issued at Par

If the rate employed by the investment community (buyers) is the same as the stated rate, the bond
sells at par. That is, the par value equals the present value of the bonds computed by the buyers (and
the current purchase price). To illustrate the computation of the present value of a bond issue,
assume that Santos SA issues R$100,000 in bonds dated January 1, 2022, due in five years with 9
percent interest payable annually on January 1. At the time of issue, the market rate for such bonds is
9 percent. The time diagram in Illustration 14.1 depicts both the interest and the principal cash
flows.
ILLUSTRATION 14.1 Time Diagram for Bonds Issued at Par

The actual principal and interest cash flows are discounted at a 9 percent rate for five periods, as
shown in Illustration 14.2.
Present value of the principal:
R$100,000 × .64993 (Table 6.2) R$ 64,993
Present value of the interest payments:
R$9,000 × 3.88965 (Table 6.4) 35,007
Present value (selling price) of the bonds R$100,000
ILLUSTRATION 14.2 Present Value Computation of Bond Selling at Par

By paying R$100,000 (the par value) at the date of issue, investors realize an effective rate or yield of
9 percent over the five-year term of the bonds. Santos makes the following entries in the first year of
the bonds.
Bonds Issued at Discount or Premium
If the rate employed by the investment community (buyers) differs from the stated rate, the present
value of the bonds computed by the buyers (and the current purchase price) will differ from the face
value of the bonds. The difference between the face value and the present value of the bonds
determines the actual price that buyers pay for the bonds. This difference is either a discount or
premium.1
If the bonds sell for less than face value, they sell at a discount.
If the bonds sell for more than face value, they sell at a premium.
The rate of interest actually earned by the bondholders is called the effective yield or market rate.
If bonds sell at a discount, the effective yield exceeds the stated rate. Conversely, if bonds sell at a
premium, the effective yield is lower than the stated rate. Several variables affect the bond’s price
while it is outstanding, most notably the market rate of interest. There is an inverse relationship
between the market interest rate and the price of the bond.
To illustrate, assume now that Santos issues R$100,000 in bonds, due in five years with 9 percent
interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11
percent. The time diagram in Illustration 14.3 depicts both the interest and the principal cash flows.
ILLUSTRATION 14.3 Time Diagram for Bonds Issued at a Discount

The actual principal and interest cash flows are discounted at an 11 percent rate for five periods, as
Present value of the principal:
R$100,000 × .59345 (Table 6.2) R$59,345
Present value of the interest payments:
R$9,000 × 3.69590 (Table 6.4) 33,263
Present value (selling price) of the bonds R$92,608
ILLUSTRATION 14.4 Present Value Computation of Bond Selling at a Discount

By paying R$92,608 at the date of issue, investors realize an effective rate or yield of 11 percent over
the five-year term of the bonds. These bonds would sell at a discount of R$7,392 (R$100,000 −
R$92,608). The price at which the bonds sell is typically stated as a percentage of the face or par value
of the bonds. For example, the Santos bonds sold for 92.6 (92.6% of par). If Santos had received
R$102,000, then the bonds sold for 102 (102% of par).
When bonds sell at less than face value, it means that investors demand a rate of interest higher than
the stated rate. Usually, this occurs because the investors can earn a higher rate on alternative
investments of equal risk. The investors cannot change the stated rate, so they refuse to pay face value
for the bonds. Thus, by changing the amount invested, they alter the effective rate of return. The
investors receive interest at the stated rate computed on the face value, but they actually earn at an
effective rate that exceeds the stated rate because they paid less than face value for the
bonds. (Later in the chapter, Illustrations 14.8 and 14.9 present a bond that sells at a premium.)

How About a 100-Year Bond?
Yes, some companies issue bonds with maturities that exceed a person’s lifetime. For example,
Électricité de France S.A. (FRA) in early 2014 sold 100-year bonds in Europe. In addition,
countries such as Ireland and Mexico have recently sold 100-year government bonds.
Why do these companies and countries issue 100-year bonds? A number of investors, such as
pension funds and insurance companies, have non-current liabilities. They need long-duration
assets to reduce an asset-liability mismatch. While investing in a 100-year bond carries interest-
rate risk, long-term debt has an offsetting effect against long-duration assets. Thus, this group of
investors has a strong demand for these bonds.
Other multibillion-dollar companies, such as Walt Disney Company (USA) and The Coca-
Cola Company (USA), have issued 100-year bonds in the past. Many of these bonds and
debentures contain an option that lets the debt issuer partially or fully repay the debt long before
the scheduled maturity. For example, the 100-year bond that Disney issued in 1993 is supposed
to mature in 2093, but the company can start repaying the bonds any time after 30 years (2023).
You may be surprised to learn that 1,000-year bonds also exist. A few issuers, such as the
Canadian Pacific Corporation (CAN), have issued such bonds in the past. And, there have
also been instances of bonds issued with no maturity date at all, meaning that the debt issuers
continue fulfilling the coupon payments forever. These types of financial instruments are
commonly referred to as perpetuities.
Sources: Albert Phung, “Why Do Companies Issue 100-Year Bonds?” Investopedia (February 2009); K. Linsell, “EDF’s
Borrowing Exceeds $12 Billion This Week with 100-Year Bond,” Bloomberg (January 17, 2014); and Dara Doyle, “Ireland Sells
First 100-Year Bond, Staying On Comeback Trail,” Bloomberg (March 16, 2016).
Effective-Interest Method
As discussed earlier, by paying more or less at issuance, investors earn a rate different than the
coupon rate on the bond. Recall that the issuing company pays the contractual interest rate over the
term of the bonds but also must pay the face value at maturity. If the bond is issued at a discount, the
amount paid at maturity is more than the issue amount. If issued at a premium, the company pays
less at maturity relative to the issue price.
The company records this adjustment to the cost as bond interest expense over the life of the
bonds through a process called amortization. Amortization of a discount increases bond
interest expense. Amortization of a premium decreases bond interest expense.
The required procedure for amortization of a discount or premium is the effective-interest method
(also called present value amortization). Under the effective-interest method, companies: [1] (See
the Authoritative Literature References section near the end of the chapter.)
1. Compute bond interest expense first by multiplying the carrying value (book value) of the
bonds at the beginning of the period by the effective-interest rate.2
2. Determine the bond discount or premium amortization next by comparing the bond interest
expense with the interest (cash) to be paid.
Illustration 14.5 depicts graphically the computation of the amortization.
ILLUSTRATION 14.5 Bond Discount and Premium Amortization Computation

The effective-interest method produces a periodic interest expense equal to a constant percentage
of the carrying value of the bonds.3
Bonds Issued at a Discount

To illustrate amortization of a discount under the effective-interest method, assume Evermaster AG
issued €100,000 of 8 percent term bonds on January 1, 2022, due on January 1, 2027, with interest
payable each July 1 and January 1. Because the investors required an effective-interest rate of 10
percent, they paid €92,278 for the €100,000 of bonds, creating a €7,722 discount. Evermaster
computes the €7,722 discount as shown in Illustration 14.6.4
Maturity value of bonds payable €100,000

Present value of €100,000 due in 5 years at 10%, interest payable semiannually
(Table 6.2); FV(PVF10,5%); (€100,000 × .61391) €61,391
Present value of €4,000 interest payable semiannually for 5 years at 10% annually
(Table 6.4); R(PVF-OA10,5%); (€4,000 × 7.72173) 30,887
Proceeds from sale of bonds (92,278)
Discount on bonds payable € 7,722
ILLUSTRATION 14.6 Computation of Discount on Bonds Payable

The five-year amortization schedule appears in Illustration 14.7.
Schedule of Bond Discount Amortization
Effective-Interest Method—Semiannual Interest Payments
5-Year, 8% Bonds Sold to Yield 10%
Carrying
Cash Interest Discount Amount
Date Paid Expense Amortized of Bonds
1/1/22 € 92,278
7/1/22 € 4,000a € 4,614b € 614c 92,892d
1/1/23 4,000 4,645 645 93,537
7/1/23 4,000 4,677 677 94,214
1/1/24 4,000 4,711 711 94,925
7/1/24 4,000 4,746 746 95,671
1/1/25 4,000 4,783 783 96,454
7/1/25 4,000 4,823 823 97,277
1/1/26 4,000 4,864 864 98,141
7/1/26 4,000 4,907 907 99,048
1/1/27 4,000 4,952 952 100,000
€40,000 €47,722 €7,722
a€4,000 = €100,000 × .08 × 6/ c€614 = €4,614 − €4,000
12
b€4,614 = €92,278 × .10 × 6/12 d€92,892 = €92,278 + €614
ILLUSTRATION 14.7 Bond Discount Amortization Schedule
Evermaster records the issuance of its bonds at a discount on January 1, 2022, as follows.
Cash 92,278
Bonds Payable 92,278
It records the first interest payment on July 1, 2022, and amortization of the discount as follows.
Interest Expense 4,614
Bonds Payable 614
Cash 4,000
Evermaster records the interest expense accrued at December 31, 2022 (year-end), and amortization
of the discount as follows.
Interest Payable 4,000
Bonds Payable 645
Bonds Issued at a Premium

Now assume that for the bond issue described above, investors are willing to accept an effective-
interest rate of 6 percent. In that case, they would pay €108,530 or a premium of €8,530, computed as
Maturity value of bonds payable €100,000
Present value of €100,000 due in 5 years at 6%, interest payable semiannually
(Table 6.2); FV(PVF10,3%); (€100,000 × .74409) €74,409
Present value of €4,000 interest payable semiannually for 5 years at 6% annually
(Table 6.4); R(PVF-OA10,3%); (€4,000 × 8.53020) 34,121
Proceeds from sale of bonds (108,530)
Premium on bonds payable € 8,530
ILLUSTRATION 14.8 Computation of Premium on Bonds Payable

The five-year amortization schedule appears in Illustration 14.9.
Schedule of Bond Premium Amortization
Carrying
Cash Interest Premium Amount
1/1/22 €108,530
7/1/22 € 4,000a € 3,256b € 744c 107,786d
1/1/23 4,000 3,234 766 107,020
7/1/23 4,000 3,211 789 106,231
1/1/24 4,000 3,187 813 105,418
7/1/24 4,000 3,163 837 104,581
1/1/25 4,000 3,137 863 103,718
7/1/25 4,000 3,112 888 102,830
1/1/26 4,000 3,085 915 101,915
7/1/26 4,000 3,057 943 100,972
1/1/27 4,000 3,029 972 100,000
€40,000 €31,471 €8,529*
a€4,000 = €100,000 × .08 × 6/ c€744 = €4,000 − €3,256
12
b€3,256 = €108,530 × .06 × 6/12 d€107,786 = €108,530 − €744
*Rounded
ILLUSTRATION 14.9 Bond Premium Amortization Schedule
Evermaster records the issuance of its bonds at a premium on January 1, 2022, as follows.
Cash 108,530
Evermaster records the first interest payment on July 1, 2022, and amortization of the premium as
follows.
Bonds Payable 744
Cash 4,000
Evermaster should amortize the discount or premium as an adjustment to interest expense over the
life of the bond in such a way as to result in a constant rate of interest when applied to the carrying
amount of debt outstanding at the beginning of any given period.5
Accruing Interest
In our previous examples, the interest payment dates and the date the financial statements were
issued were essentially the same. For example, when Evermaster sold bonds at a premium, the two
interest payment dates coincided with the financial reporting dates. However, what happens if
Evermaster prepares financial statements at the end of February, 2022? In this case, as Illustration
14.10 shows, the company prorates the premium by the appropriate number of months to arrive at
the proper interest expense.
Interest accrual (€4,000 × 2/6) €1,333.33

Premium amortized (€744 × 2/6) (248.00)
Interest expense (Jan.–Feb.) €1,085.33
ILLUSTRATION 14.10 Computation of Interest Expense

Evermaster records this accrual as follows.
Interest Expense 1,085.33
Bonds Payable 248.00
Interest Payable 1,333.33
If the company prepares financial statements six months later, it follows the same procedure. That is,
the premium amortized would be as shown in Illustration 14.11.
Premium amortized (March–June) (€744 × 4/6) €496.00
Premium amortized (July–August) (€766 × 2/6) 255.33
Premium amortized (March–August 2022) €751.33
ILLUSTRATION 14.11 Computation of Premium Amortization
Bonds Issued Between Interest Dates

Companies usually make bond interest payments semiannually, on dates specified in the bond
indenture. When companies issue bonds on other than the interest payment dates, bond investors
will pay the issuer the interest accrued from the last interest payment date to the date of
issue. The bond investors, in effect, pay the bond issuer in advance for that portion of the full six-
months’ interest payment to which they are not entitled because they have not held the bonds for that
period. Then, on the next semiannual interest payment date, the bond investors will
receive the full six-months’ interest payment.
Bonds Issued at Par

To illustrate, assume that instead of issuing its bonds on January 1, 2022, Evermaster issued its five-
year bonds, dated January 1, 2022, on May 1, 2022, at par (€100,000). Evermaster records the
issuance of the bonds between interest dates as follows.
May 1, 2022
May 1, 2022
Cash 100,000
(To record issuance of bonds at par)
Cash 2,667
Interest Expense (€100,000 × .08 × 4/12) 2,667
(To record accrued interest; Interest Payable might be credited instead)
Because Evermaster issues the bonds between interest dates, it records the bond issuance at par
(€100,000) plus accrued interest (€2,667). That is, the total amount paid by the bond investor
includes four months of accrued interest.
On July 1, 2022, two months after the date of purchase, Evermaster pays the investors six months’
interest, by making the following entry.
Interest Expense
5/1/22 2,667a
7/1/22 4,000b
Balance 1,333
aAccrued interest received.
bCash paid.
July 1, 2022
Cash 4,000
(To record first interest payment)
The Interest Expense account now contains a debit balance of €1,333 (€4,000 − €2,667), which
represents the proper amount of interest expense—two months at 8 percent on €100,000.
Bonds Issued at Discount or Premium

The illustration above was simplified by having the January 1, 2022, bonds issued on May 1, 2022, at
par. However, if the bonds are issued at a discount or premium between interest dates, Evermaster
must not only account for the partial cash interest payment but also the amount of
effective amortization for the partial period.
To illustrate, assume that the Evermaster 8-percent bonds were issued on May 1, 2022, to yield 6
percent. Thus, the bonds are issued at a premium; in this case, the price is €108,039.6 Evermaster
records the issuance of the bonds between interest dates as follows.
May 1, 2022
Cash 108,039
(To record the present value of the cash flows)
Cash 2,667
Interest Expense (€100,000 × .08 × 4/ )
12 2,667
May 1, 2022
(To record accrued interest; Interest Payable might be credited instead)
In this case, Evermaster receives a total of €110,706 at issuance, comprised of the bond price of
€108,039 plus the accrued interest of €2,667. Following the effective-interest procedures, Evermaster
then determines interest expense from the date of sale (May 1, 2022), not from the date of the bonds
(January 1, 2022). Illustration 14.12 provides the computation, using the effective-interest rate of 6
percent. The bond interest expense therefore for the two months (May and June) is €1,080.
Interest Expense
Carrying value of bonds €108,039
Effective-interest rate (.06 × 2/12) 1%
Interest expense for two months € 1,080
ILLUSTRATION 14.12 Partial Period Interest Amortization

The premium amortization of the bonds is also for only two months. It is computed by taking the
difference between the net cash paid related to bond interest and the effective-interest expense of
€1,080. Illustration 14.13 shows the computation of the partial amortization, using the effective-
interest rate of 6 percent.
Cash interest paid on July 1, 2022 (€100,000 × .08 × 6/12) €4,000

Less: Cash interest received on May 1, 2022 2,667
Net cash paid €1,333
Bond interest expense (at the effective rate) for two months (1,080)
Premium amortization € 253
ILLUSTRATION 14.13 Partial Period Interest Amortization

As indicated, both the bond interest expense and amortization reflect the shorter two-month period
between the issue date and the first interest payment. Evermaster therefore makes the following
entries on July 1, 2022, to record the interest payment and the premium amortization.
Interest Expense
5/1/22 2,667a
7/1/22 4,000b 7/1/22 253c
Balance 1,080
aAccrued interest received.
bCash paid.
c2 months’ amortization.
July 1, 2022
Cash 4,000
(To record first interest payment)
Bonds Payable 253
Interest Expense 253
(To record two months’ premium amortization)
The Interest Expense account now contains a debit balance of €1,080 (€4,000 − €2,667 − €253),
which represents the proper amount of interest expense—two months at an effective annual interest
rate of 6 percent on €108,039.
Long-Term Notes Payable
Explain the accounting for long-term notes payable.
The difference between current notes payable and long-term notes payable is the maturity date. As
discussed in Chapter 13, short-term notes payable are those that companies expect to pay within a year
or the operating cycle—whichever is longer. Long-term notes are similar in substance to bonds in that
both have fixed maturity dates and carry either a stated or implicit interest rate. However, notes do not
trade as readily as bonds in the organized public securities markets. Small companies commonly issue
notes as their long-term instruments. Larger companies issue both long-term notes and bonds.
Accounting for notes and bonds is quite similar. Like a bond, a note is valued at the present
value of its future interest and principal cash flows. The company amortizes any discount
or premium over the life of the note, just as it would the discount or premium on a bond.
Companies compute the present value of an interest-bearing note, record its issuance, and
amortize any discount or premium and accrual of interest in the same way that they do for bonds.
As you might expect, accounting for long-term notes payable parallels accounting for long-term notes
receivable, as Chapter 7 demonstrated.
Notes Issued at Face Value

In Chapter 7, we discussed the recognition of a €10,000, three-year note Scandinavian Imports issued
at face value to Bigelow ASA. In this transaction, the stated rate and the effective rate were both 10
percent. The time diagram and present value computation in Chapter 7 (see Illustration 7.12) for
Bigelow would be the same for the issuer of the note, Scandinavian Imports, in recognizing a note
payable. Because the present value of the note and its face value are the same, €10,000, Scandinavian
would recognize no premium or discount. It records the issuance of the note as follows.
Cash 10,000
Notes Payable 10,000
Scandinavian Imports would recognize the interest incurred each year as follows.
Interest Expense (€10,000 × .10) 1,000
Cash 1,000
Notes Not Issued at Face Value

Zero-Interest-Bearing Notes
If a company issues a zero-interest-bearing (non-interest-bearing) note7 solely for cash, it measures
the note’s present value by the cash received. The implicit interest rate is the rate that equates the
cash received with the amounts to be paid in the future. The issuing 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.
An example of such a transaction is Beneficial Corporation’s (USA) offering of $150 million of
zero-coupon notes (deep-discount bonds) having an eight-year life. With a face value of $1,000 each,
these notes sold for $327—a deep discount of $673 each. The present value of each note is the cash
proceeds of $327. We can calculate the interest rate by determining the rate that equates the amount
the investor currently pays with the amount to be received in the future. Thus, Beneficial amortizes
the discount over the eight-year life of the notes using an effective-interest rate of 15 percent.8
To illustrate the entries and the amortization schedule, assume that Turtle Cove Company issued the
three-year, $10,000, zero-interest-bearing note to Jeremiah Company illustrated in Chapter 7 (notes
receivable). The implicit rate that equated the total cash to be paid ($10,000 at maturity) to the
present value of the future cash flows ($7,721.80 cash proceeds at date of issuance) was 9 percent.
(The present value of $1 for three periods at 9 percent is $0.77218.) Illustration 14.14 shows the
time diagram for the single cash flow.
ILLUSTRATION 14.14 Time Diagram for Zero-Interest Note

Turtle Cove records issuance of the note as follows.
Cash 7,721.80
Notes Payable 7,721.80
Turtle Cove amortizes the discount and recognizes interest expense annually using the effective-
interest method. Illustration 14.15 shows the three-year discount amortization and interest
expense schedule. (This schedule is similar to the note receivable schedule of Jeremiah Company in
Illustration 7.14.)
Schedule of Note Discount Amortization
0% Note Discounted at 9%
Carrying
Paid Expense Amortized of Note
Date of issue $ 7,721.80
End of year 1 $–0– $ 694.96a $ 694.96b 8,416.76c
End of year 2 –0– 757.51 757.51 9,174.27
End of year 3 –0– 825.73d 825.73 10,000.00
$–0– $2,278.20 $2,278.20
a$7,721.80 × .09 = $694.96 c$7,721.80 + $694.96 = $8,416.76
b$694.96 − $0 = $694.96 d5¢ adjustment to compensate for rounding.
ILLUSTRATION 14.15 Schedule of Note Discount Amortization

Turtle Cove records interest expense at the end of the first year using the effective-interest method as
follows.
Interest Expense ($7,721.80 × .09) 694.96
Notes Payable 694.96
The total amount of the discount, $2,278.20 in this case, represents the expense that Turtle Cove
Company will incur on the note over the three years.
Interest-Bearing Notes
The zero-interest-bearing note above is an example of the extreme difference between the stated rate
and the effective rate. In many cases, the difference between these rates is not so great.
Consider the example from Chapter 7 where Marie Co. issued for cash a €10,000, three-year note
bearing interest at 10 percent to Morgan Group. The market rate of interest for a note of similar risk is
12 percent. Illustration 7.15 shows the time diagram depicting the cash flows and the computation of
the present value of this note. In this case, because the effective rate of interest (12%) is greater than
the stated rate (10%), the present value of the note is less than the face value. That is, the note is
exchanged at a discount. Marie Co. records the issuance of the note as follows.
Cash 9,520
Notes Payable 9,520
Marie Co. then amortizes the discount and recognizes interest expense annually using the effective-
interest method. Illustration 14.16 shows the three-year discount amortization and interest
expense schedule.
10% Note Discounted at 12%
Carrying
Paid Expense Amortized of Note
Date of issue € 9,520
End of year 1 €1,000a €1,142b €142c 9,662d
End of year 2 1,000 1,159 159 9,821
End of year 3 1,000 1,179 179 10,000
€3,000 €3,480 €480
a€10,000 × .10 = €1,000 c€1,142 − €1,000 = €142
b€9,520 × .12 = €1,142 d€9,520 + €142 = €9,662
ILLUSTRATION 14.16 Schedule of Note Discount Amortization

Marie Co. records payment of the annual interest and amortization of the discount for the first year as
follows (amounts per amortization schedule).
Notes Payable 142
Cash 1,000
When the present value exceeds the face value, Marie Co. issues the note at a premium. It does so by
recording the premium as a credit to Notes Payable and amortizing it using the effective-interest
method over the life of the note as annual reductions in the amount of interest expense recognized.
Negative Interest Rates—Is That Even Possible?
Starting around 2014, a number of debt securities were issued that paid a negative interest rate.
Most of us understand that interest rates rise and fall, but negative interest rates are something
altogether different. The presence of debt securities paying negative interest rates raises a
number of questions.
1. What is a negative interest rate? In a negative interest rate debt offering, the investor
provides money to the borrower, and over the lifetime of the investment receives back a
smaller amount than the original investment. This is the opposite of a traditional (positive
interest rate) debt offering, where the amount received over the lifetime of the investment is
greater than the amount invested.
2. Who would issue this kind of debt? The most common issuers have been central banks.
Central banks are components or affiliates of the central governments of various countries
and regions. For example, Deutsche Bundesbank (DEU) is the central bank of the Federal
Republic of Germany. Similarly, the European Central Bank (ECB) is the central bank of
the European Union. Central banks have a variety of functions related to monetary policy,
with the principle aim to assist governments to achieve various economic objectives related
to employment and economic growth. (However, while the majority of negative interest rate
borrowings are issued by central banks, a small number of businesses, including LVMH
(FRA), Sanofi (FRA), and Henkel (DEU), have issued debt that has traded a zero and/or
negative rate.)
For example, in the years following the economic crisis of 2008–2009, the economies of
countries in the European Union began to recover and for several years showed healthy
growth. However, during 2014, the growth began to slow and overall growth in the EU lagged
behind many of the other economies around the world. Typically, during this kind of period,
central banks will reduce interest rates with an expectation that making funds “cheaper” will
stimulate the economy. However, the ECB, like many other central banks, had already
reduced its rates. For example, by the end of 2011, the ECB rate was at .25 percent, which
was then cut in 2012 to zero. In 2014, still hoping to stimulate the lagging European
economy, the ECB lowered rates again. Since rates were already at zero, this meant that the
rates were reduced to a negative rate: first to −.10 percent and then to −.20 percent. The ECB
has continued to cut rates to this day, with the current rate set at −.50 percent. This strategy
was not limited to Europe alone. For example, the yield on Japanese 10-year government
bonds was negative in 2016 and again in 2019.
3. Who would invest in negative interest rate debt? While a variety of investors purchase
debt, a subset of debt investors tend to be the primary investors in negative interest rate
debt. The most prominent investors tend to be in the financial services industry, such as
banks, mutual funds, and insurance companies. The reason they are willing to accept this
negative return has to do with regulatory requirements and business practices, such as
banks that have a regulatory requirement to hold a portion of their assets in very low risk
and highly liquid securities. To fulfil this requirement, banks have almost always invested in
debts from central banks since they are backed by these banks’ national governments and
are viewed as essentially risk-free.
What does the future hold? Will we continue to see debt issued with negative yield? Will it
continue to be common practice for a central bank to reduce interest rates to stimulate the
economy, even when cutting rates means lowering them to below zero? Numerous questions
accompany this recent phenomenon and remain to be answered in full.
Sources: Jonathan Soble, “Japan’s Negative Interest Rates Explained,” The New York Times (September 20, 2016); Brian
Blackstone, “Negative Rates, Designed as a Short-Term Jolt, Have Become an Addiction,” Wall Street Journal (May 20, 2019);
and James Mackintosh “There’s Too Much Negativity About Negative Rates,” Wall Street Journal, (September 10, 2019).
Special Notes Payable Situations

Notes Issued for Property, Goods, or Services
Sometimes, companies may receive property, goods, or services in exchange for a note payable. When
exchanging the debt instrument for property, goods, or services in a bargained transaction entered into
at arm’s length, the stated interest rate is presumed to be fair unless:
1. No interest rate is stated, or

2. The stated interest rate is unreasonable, or
3. The stated face amount of the debt instrument is materially different from the current cash sales
price for the same or similar items or from the current fair value of the debt instrument.
In these circumstances, the company measures the present value of the debt instrument by the fair
value of the property, goods, or services or by an amount that reasonably approximates the fair value
of the note. [3] If there is no stated rate of interest, the amount of interest is the difference
between the face amount of the note and the fair value of the property.
For example, assume that Scenic Development AS sells land having a cash sale price of €200,000 to
Health Spa Services. In exchange for the land, Health Spa gives a five-year, €293,866, zero-interest-
bearing note. The €200,000 cash sale price represents the present value of the €293,866 note
discounted at 8 percent for five years. Should both parties record the transaction on the sale date at
the face amount of the note, which is €293,866? No—if they did, Health Spa’s Land account and
Scenic’s sales would be overstated by €93,866 (the interest for five years at an effective rate of 8
percent). Similarly, interest revenue to Scenic and interest expense to Health Spa for the five-year
period would be understated by €93,866.
Because the difference between the cash sale price of €200,000 and the €293,866 face amount of the
note represents interest at an effective rate of 8 percent, the companies’ transaction is recorded at the
exchange date as shown in Illustration 14.17.
Health Spa Services (Buyer) Scenic Development AS (Seller)

Land 200,000 Notes Receivable 200,000
Notes Payable 200,000 Sales Revenue 200,000
ILLUSTRATION 14.17 Entries for Non-Cash Note Transaction

During the five-year life of the note, Health Spa amortizes annually a portion of the discount of
€93,866 as a charge to interest expense. Scenic Development records interest revenue totaling
€93,866 over the five-year period by also amortizing the discount, using the effective-interest method.
Choice of Interest Rate

In note transactions, the effective or market interest rate is either evident or determinable by other
factors involved in the exchange, such as the fair value of what is given or received. But, if a company
cannot determine the fair value of the property, goods, services, or other rights, and if the note has no
ready market, determining the present value of the note is more difficult. To estimate the present
value of a note under such circumstances, a company must approximate an applicable interest rate
that may differ from the stated interest rate. This process of interest-rate approximation is called
imputation, and the resulting interest rate is called an imputed interest rate.
The prevailing rates for similar instruments of issuers with similar credit ratings affect the choice of a
rate. Other factors, such as restrictive covenants, collateral, payment schedule, and the existing prime
interest rate, also play a part. Companies determine the imputed interest rate when they issue a note;
any subsequent changes in prevailing interest rates are ignored.
To illustrate, assume that on December 31, 2022, Wunderlich plc issued a promissory note and to
Brown Interiors Company for architectural services. The note has a face value of £550,000, a due date
of December 31, 2027, and also bears a stated interest rate of 2 percent, payable at the end of each
year. Wunderlich cannot readily determine the fair value of the architectural services, nor is the note
readily marketable. On the basis of Wunderlich’s credit rating, the absence of collateral, the prime
interest rate at that date, and the prevailing interest on Wunderlich’s other outstanding debt, the
company imputes an 8 percent interest rate as appropriate in this circumstance. Illustration 14.18
shows the time diagram depicting both cash flows.
ILLUSTRATION 14.18 Time Diagram for Interest-Bearing Note

Illustration 14.19 shows the calculation of the present value of the note and the imputed fair value
of the architectural services.
Face value of the note £550,000
Present value of £550,000 due in 5 years at 8% interest payable annually (Table
6.2); FV(PVF5,8%); (£550,000 × .68058) £374,319
Present value of £11,000 interest payable annually for 5 years at 8%; R(PVF-
OA5,8%); (£11,000 × 3.99271) 43,920
Present value of the note (418,239)
Discount on notes payable £131,761
ILLUSTRATION 14.19 Computation of Imputed Fair Value and Note Discount

Wunderlich records issuance of the note in payment for the architectural services as follows.
December 31, 2022
Buildings (or Construction in Process) 418,239
The five-year amortization schedule is presented in Illustration 14.20.
2% Note Discounted at 8% (Imputed)
Cash Interest Carrying
Paid Expense Discount Amount
Date (2%) (8%) Amortized of Note
12/31/22 £418,239
12/31/23 £11,000a £ 33,459b £ 22,459c 440,698d
12/31/24 11,000 35,256 24,256 464,954
12/31/25 11,000 37,196 26,196 491,150
12/31/26 11,000 39,292 28,292 519,442
12/31/27 11,000 41,558e 30,558 550,000
£55,000 £186,761 £131,761
a£550,000 × .02 = £11,000 d£418,239 + £22,459 = £440,698
b£418,239 × .08 = £33,459 e£3 adjustment to compensate for rounding.
c£33,459 − £11,000 = £22,459
ILLUSTRATION 14.20 Schedule of Discount Amortization Using Imputed Interest Rate
Wunderlich records payment of the first year’s interest and amortization of the discount as follows.
December 31, 2023
Cash 11,000
Mortgage Notes Payable

A common form of long-term notes payable is a mortgage note payable. A mortgage note payable is
a promissory note secured by a document called a mortgage that pledges title to property as security
for the loan. Individuals, proprietorships, and partnerships use mortgage notes payable more
frequently than do larger companies (which usually find that bond issues offer advantages in
obtaining large loans).
The borrower usually receives cash for the face amount of the mortgage note. In that case, the face
amount of the note is the true liability, and no discount or premium is involved. When the lender
assesses “points,” however, the total amount received by the borrower is less than the face amount of
the note.9 Points raise the effective-interest rate above the rate specified in the note. A point is 1
percent of the face of the note.
For example, assume that Harrick Co. borrows $1,000,000, signing a 20-year mortgage note with a
stated interest rate of 10.75 percent as part of the financing for a new plant. If Associated Savings
demands 4 points to close the financing, Harrick will receive 4 percent less than $1,000,000—or
$960,000—but it will be obligated to repay the entire $1,000,000 at the rate of $10,150 per month.
Because Harrick received only $960,000 and must repay $1,000,000, its effective-interest rate is
increased to approximately 11.3 percent on the money actually borrowed.
On the statement of financial position, Harrick should report the mortgage note payable as a liability
using a title such as “Mortgage Notes Payable” or “Notes Payable—Secured,” with a brief disclosure of
the property pledged in notes to the financial statements.
Mortgages may be payable in full at maturity or in installments over the life of the loan. If payable at
maturity, Harrick classifies its mortgage payable as a non-current liability on the statement of
financial position until such time as the approaching maturity date warrants showing it as a current
liability. If it is payable in installments, Harrick shows the current installments due as current
liabilities, with the remainder as a non-current liability.
Lenders have partially replaced the traditional fixed-rate mortgage with alternative mortgage
arrangements. Most lenders offer variable-rate mortgages (also called floating-rate or adjustable-
rate mortgages) featuring interest rates tied to changes in the fluctuating market rate. Generally, the
variable-rate lenders adjust the interest rate at either one- or three-year intervals, pegging the
adjustments to changes in the prime rate or the London Interbank Offering rate (LIBOR).10
Extinguishment of Non-Current Liabilities
Explain the accounting for extinguishment of non-current liabilities.
How do companies record the payment of non-current liabilities—often referred to as

extinguishment of debt? If a company holds the bonds (or any other form of debt security) to
maturity, the answer is straightforward: The company does not compute any gains or losses. It will
have fully amortized any premium or discount at the date the bonds mature. As a result, the carrying
amount, the maturity (face) value, and the fair value of the bond are the same. Therefore, no gain or
loss exists.
In this section, we discuss extinguishment of debt under three common additional situations:
1. Extinguishment with cash before maturity.

2. Extinguishment by transferring assets or securities.
3. Extinguishment with modification of terms.
Extinguishment with Cash Before Maturity

In some cases, a company extinguishes debt before its maturity date.11 The amount paid on
extinguishment or redemption before maturity, including any call premium and expense of
reacquisition, is called the reacquisition price. On any specified date, the carrying amount of the
bonds is the amount payable at maturity, adjusted for unamortized premium or discount. Any excess
of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess
of the reacquisition price over the carrying amount is a loss from extinguishment. At the time of
reacquisition, the unamortized premium or discount must be amortized up to the
reacquisition date.
To illustrate, we use the Evermaster bonds issued at a discount on January 1, 2022. These bonds are
due in five years. The bonds have a par value of €100,000, a coupon rate of 8 percent paid
semiannually, and were sold to yield 10 percent. The amortization schedule for the Evermaster bonds
is presented in Illustration 14.21.
Schedule of Bond Discount Amortization

Carrying
1/1/22 € 92,278
7/1/22 € 4,000a € 4,614b € 614c 92,892d
1/1/23 4,000 4,645 645 93,537
7/1/23 4,000 4,677 677 94,214
1/1/24 4,000 4,711 711 94,925
7/1/24 4,000 4,746 746 95,671
1/1/25 4,000 4,783 783 96,454
7/1/25 4,000 4,823 823 97,277
1/1/26 4,000 4,864 864 98,141
7/1/26 4,000 4,907 907 99,048
1/1/27 4,000 4,952 952 100,000
€40,000 €47,722 €7,722
a€4,000 = €100,000 × .08 × 6/ c€614 = €4,614 − €4,000
12
b€4,614 = €92,278 × .10 × 6/12 d€92,892 = €92,278 + €614
ILLUSTRATION 14.21 Bond Premium Amortization Schedule, Bond Extinguishment

On January 1, 2024, two years after the issue date, Evermaster calls the entire issue at 101 and cancels
it.12 As indicated in the amortization schedule, the carrying value of the bonds on January 1, 2024, is
€94,925. Illustration 14.22 indicates how Evermaster computes the loss on redemption
(extinguishment).
Reacquisition price (€100,000 × 1.01) €101,000
Carrying amount of bonds redeemed (94,925)
Loss on extinguishment € 6,075
ILLUSTRATION 14.22 Computation of Loss on Redemption of Bonds

Evermaster records the reacquisition and cancellation of the bonds as follows.
Loss on Extinguishment of Debt 6,075
Cash 101,000
Note that it is often advantageous for the issuer to acquire the entire outstanding bond issue and
replace it with a new bond issue bearing a lower rate of interest. The replacement of an existing
issuance with a new one is called refunding. Whether the early redemption or other extinguishment
of outstanding bonds is a non-refunding or a refunding situation, a company should recognize the
difference (gain or loss) between the reacquisition price and the carrying amount of the redeemed
bonds in income (in other income and expenses) of the period of redemption.
Extinguishment by Exchanging Assets or Securities

In addition to using cash, settling a debt obligation can involve either a transfer of non-cash assets
(real estate, receivables, or other assets) or the issuance of the debtor’s shares. In these situations, the
creditor should account for the non-cash assets or equity interest received at their fair
value.
The debtor must determine the excess of the carrying amount of the payable over the fair value of the
assets or equity transferred (gain).13 The debtor recognizes a gain equal to the amount of the excess.
In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair
value of those assets differs from their carrying amount (book value).
Transfer of Assets
Assume that Hamburg Bank loaned €20,000,000 to Bonn Mortgage Company. Bonn, in turn, invested
these monies in residential apartment buildings. However, because of low occupancy rates, it cannot
meet its loan obligations. Hamburg Bank agrees to accept real estate with a fair value of €16,000,000
from Bonn Mortgage in full settlement of the €20,000,000 loan obligation. The real estate has a
carrying value of €21,000,000 on the books of Bonn Mortgage. Bonn (debtor) records this transaction
as follows.
Notes Payable (to Hamburg Bank) 20,000,000
Loss on Disposal of Real Estate (€21,000,000 − €16,000,000) 5,000,000
Real Estate 21,000,000
Gain on Extinguishment of Debt (€20,000,000 − €16,000,000) 4,000,000
Bonn Mortgage has a loss on the disposition of real estate in the amount of €5,000,000 (the
difference between the €21,000,000 book value and the €16,000,000 fair value). In addition, it has a
gain on settlement of debt of €4,000,000 (the difference between the €20,000,000 carrying amount
of the note payable and the €16,000,000 fair value of the real estate).
Granting of Equity Interest

Now assume that Hamburg Bank agrees to accept from Bonn Mortgage 320,000 ordinary shares (€10
par) that have a fair value of €16,000,000, in full settlement of the €20,000,000 loan obligation. Bonn
Mortgage (debtor) records this transaction as follows.
Notes Payable (to Hamburg Bank) 20,000,000
Share Capital—Ordinary (320,000 × €10) 3,200,000
Share Premium—Ordinary (€16,000,000 − €3,200,000) 12,800,000
Gain on Extinguishment of Debt 4,000,000
It records the ordinary shares issued in the normal manner. It records the difference between the par
value and the fair value of the shares as share premium.
Extinguishment with Modification of Terms

Practically every day, the Wall Street Journal or the Financial Times runs a story about some company
in financial difficulty, such as Japan Display (JPN) or Bayer AG (DEU). In many of these
situations, a creditor may grant a borrower concessions with respect to settlement. The creditor offers
these concessions to ensure the highest possible collection on the loan. For example, a creditor may
offer one or a combination of the following modifications:
1. Reduction of the stated interest rate.

2. Extension of the maturity date of the face amount of the debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.
As with other extinguishments, when a creditor grants favorable concessions on the terms of a loan,
the debtor has an economic gain. Thus, the accounting for modifications is similar to that for other
extinguishments. That is, the original obligation is extinguished, the new payable is recorded at fair
value, and a gain is recognized for the difference in the fair value of the new obligation and the
carrying value of the old obligation.14
To illustrate, assume that on December 31, 2022, Morgan National Bank enters into a debt
modification agreement with Resorts Development Group, which is experiencing financial difficulties.
The bank restructures a ¥10,500,000 loan receivable issued at par (interest paid to date) by:
Reducing the principal obligation from ¥10,500,000 to ¥9,000,000;

Extending the maturity date from December 31, 2022, to December 31, 2026; and
Reducing the interest rate from the historical effective rate of 12 percent to 8 percent. Given
Resorts Development’s financial distress, its market-based borrowing rate is 15 percent.
IFRS requires the modification to be accounted for as an extinguishment of the old note and issuance
of the new note, measured at fair value. [6] Illustration 14.23 shows the calculation of the fair
value of the modified note, using Resorts Development’s market discount rate of 15 percent.
Present value of restructured cash flows:

Present value of ¥9,000,000 due in 4 years at 15%, interest payable annually (Table 6.2);
FV(PVF4,15%); (¥9,000,000 × .57175) ¥5,145,750
Present value of ¥720,000* interest payable annually for 4 years at 15% (Table 6.4);
R(PVF-OA4,15%); (¥720,000 × 2.85498) 2,055,586
Fair value of note ¥7,201,336
* ¥ 9,000,000 × .08
ILLUSTRATION 14.23 Fair Value of Restructured Note

The gain on the modification is ¥3,298,664, which is the difference between the prior carrying value
(¥10,500,000) and the fair value of the restructured note, as computed in Illustration 14.23
(¥7,201,336). Given this information, Resorts Development makes the following entry to record the
modification.
Notes Payable (old) 10,500,000
Gain on Extinguishment of Debt 3,298,664
Notes Payable (new) 7,201,336
Illustration 14.24 shows the amortization schedule for the new note, following the modification.
Date Cash Paid Interest Expense Amortization Carrying Value
12/31/2022 ¥7,201,336
12/31/2023 ¥720,000a ¥1,080,200b ¥360,200c 7,561,536d
12/31/2024 720,000 1,134,230 414,230 7,975,766
12/31/2025 720,000 1,196,365 476,365 8,452,131
12/31/2026 720,000 1,267,820 547,869e 9,000,000
a¥9,000,000 × .08 c¥1,080,200 − ¥720,000 e¥49 adjustment for rounding
b¥7,201,336 × .15 d¥7,201,336 + ¥360,200
ILLUSTRATION 14.24 Schedule of Interest and Amortization after Debt Modification

Resorts Development recognizes interest expense on this note using the effective rate of 15 percent.
Thus, on December 31, 2023 (date of first interest payment after restructure), Resorts Development
makes the following entry.
December 31, 2023
Interest Expense 1,080,200
Cash 720,000
Resorts Development makes a similar entry (except for different amounts for credits to Notes Payable
and debits to Interest Expense) each year until maturity. At maturity, Resorts Development makes the
following entry.
December 31, 2026
Notes Payable 9,000,000
Cash 9,000,000
In summary, following the modification, Resorts Development has extinguished the old note with an
effective rate of 12 percent and now has a new loan with a much higher effective rate of 15 percent.
Presentation and Analysis
Indicate how to present and analyze non-current liabilities.
Fair Value Option

As indicated earlier, non-current liabilities such as bonds and notes payable are generally measured at
amortized cost (face value of the payable, adjusted for any payments and amortization of any premium
or discount). However, companies have the option to record fair value in their accounts for most
financial assets and liabilities, including bonds and notes payable. [7] As discussed in Chapter 7, the
IASB believes that fair value measurement for financial instruments, including financial liabilities,
provides more relevant and understandable information than amortized cost. It considers fair value to
be more relevant because it reflects the current cash equivalent value of financial instruments.
Fair Value Measurement

If companies choose the fair value option, non-current liabilities such as bonds and notes payable
are recorded at fair value, with unrealized holding gains or losses reported as part of net income. An
unrealized holding gain or loss is the net change in the fair value of the liability from one period
to another, exclusive of interest expense recognized but not recorded. As a result, the company reports
the liability at fair value each reporting date. In addition, it reports the change in value as part of net
income.
To illustrate, Edmonds SE issued €500,000 of 6 percent bonds at face value on May 1, 2022. Edmonds
chose the fair value option for these bonds. At December 31, 2022, the fair value of the bonds is
€480,000 because interest rates in the market increased to 8 percent. The value of the debt securities
fell because the bond paid less than market rate for similar securities. Under the fair value option,
Edmonds made the following entry.
Bonds Payable (€500,000 − €480,000) 20,000
Unrealized Holding Gain or Loss—Income 20,000
As the journal entry indicates, the value of the bonds declined. This decline leads to a reduction in the
bond liability and a resulting unrealized holding gain, which is reported as part of net income. The
value of Edmonds’ debt declined because interest rates increased. It should be emphasized that
Edmonds must continue to value the bonds payable at fair value in all subsequent periods.
Fair Value Controversy

With the Edmonds bonds, we assumed that the decline in value of the bonds was due to an interest
rate increase. In other situations, the decline may occur because the bonds become more likely to
default. That is, if the creditworthiness of Edmonds declines, the value of its debt also
declines. If its creditworthiness declines, its bond investors are receiving a lower rate relative to
investors with similar-risk investments. If Edmonds is using the fair value option, changes in the fair
value of the bonds payable for a decline in creditworthiness are included as part of income. Some
question how Edmonds can record a gain when its creditworthiness is becoming worse. As one writer
observed, “It seems counterintuitive.” However, the IASB notes that the debtholders’ loss is the
shareholders’ gain. That is, the shareholders’ claims on the assets of the company increase when the
value of the debtholders’ claims declines. In addition, the worsening credit position may indicate that
the assets of the company are declining in value as well. Thus, the company may be reporting losses
on the asset side, which will be offsetting gains on the liability side.
The IASB apparently agrees with this statement and requires that the effects of changes in a
company’s credit risk should not affect profit and loss unless the liability is held for trading. [8]
Therefore, any change in the value of the liability due to credit risk changes should be reported in
other comprehensive income. To illustrate, assume the change in the interest rate related to the
Edmonds bonds described in the previous section changed from 6 percent to 8 percent due to a
decrease in the credit quality of these bonds. Under the fair value option, Edmonds makes the
following entry.
Unrealized Holding Gain or Loss—Equity 20,000
This entry recognizes the decline in the fair value of the liability and a resulting unrealized holding
gain, which is reported as part of other comprehensive income. The value of the Edmonds bonds
declined because of the change in its credit risk, not because of general market conditions. Edmonds
then continues to value the bonds payable at fair value in all subsequent periods (see Underlying
Concepts).
Underlying Concepts
The fair value controversy represents a classic trade-off between relevance and faithful
representation.
Off-Balance-Sheet Financing
What do Air Berlin (DEU), HSBC (GBR), China Construction Bank Corp. (CHN), and Enron
(USA) have in common? They all have been accused of using off-balance-sheet financing to minimize
the reporting of debt on their statements of financial position.15 Off-balance-sheet financing is an
attempt to borrow monies in such a way as to prevent recording the obligations. It has become an
issue of extreme importance. Many allege that Enron, in one of the largest corporate failures on
record, hid a considerable amount of its debt off the statement of financial position. As a result, any
company that uses off-balance-sheet financing today risks investors dumping their shares.
Consequently, their share price will suffer. Nevertheless, a considerable amount of off-balance-sheet
financing continues to exist. As one writer noted, “The basic drives of humans are few: to get enough
food, to find shelter, and to keep debt off the balance sheet.”
Different Forms
Off-balance-sheet financing can take different forms:
1. Non-consolidated subsidiary. Under IFRS, a parent company does not have to consolidate a
subsidiary company that is less than 50 percent owned. In such cases, the parent therefore does
not report the assets and liabilities of the subsidiary. All the parent reports on its statement of
financial position is the investment in the subsidiary. As a result, users of the financial
statements may not understand that the subsidiary has considerable debt for which the parent
may ultimately be liable if the subsidiary runs into financial difficulty.
2. Special purpose entity (SPE). A company creates a special purpose entity (SPE) to
perform a special project. To illustrate, assume that Clarke Company decides to build a new
factory. However, management does not want to report the plant or the borrowing used to fund
the construction on its statement of financial position. It therefore creates an SPE, the purpose of
which is to build the plant. (This arrangement is called a project financing arrangement.) The
SPE finances and builds the plant. In return, Clarke guarantees that it or some outside party will
purchase all the products produced by the plant (sometimes referred to as a take-or-pay
contract). As a result, Clarke might not report the asset or liability on its books.
Rationale
Why do companies engage in off-balance-sheet financing? A major reason is that many believe that
removing debt enhances the quality of the statement of financial position and permits
credit to be obtained more readily and at less cost.
Second, loan covenants often limit the amount of debt a company may have. As a result, the company
uses off-balance-sheet financing because these types of commitments might not be considered
in computing debt limits.
Third, some argue that the asset side of the statement of financial position is severely understated. For
example, companies that depreciate assets on an accelerated basis will often have carrying amounts
for property, plant, and equipment that are much lower than their fair values. As an offset to these
lower values, some believe that part of the debt does not have to be reported. In other words, if
companies reported assets at fair values, less pressure would undoubtedly exist for off-balance-
sheet financing arrangements.
Whether the arguments above have merit is debatable. The general idea of “out of sight, out of mind”
may not be true in accounting. Many users of financial statements indicate that they attempt to factor
these off-balance-sheet financing arrangements into their computations when assessing debt to equity
relationships. Similarly, many loan covenants also attempt to account for these complex
arrangements. Nevertheless, many companies still believe that benefits will accrue if they omit certain
obligations from the statement of financial position.
As a response to off-balance-sheet financing arrangements, the IASB has increased disclosure (note)
requirements. This response is consistent with an “efficient markets” philosophy: The important
question is not whether the presentation is off-balance-sheet but whether the items are disclosed at
all. In addition, the U.S. SEC now requires companies that it regulates to disclose (1) all contractual
obligations in a tabular format and (2) contingent liabilities and commitments in either a textual or
tabular format. An example of this disclosure appears in the following “Evolving Issue” box.16
We believe that recording more obligations on the statement of financial position will enhance
financial reporting. Given the problems with companies such as Enron, Tiger Air (AUS), Petra
Perdana (MYS), and Washington Mutual (USA), and on-going efforts by the IASB and market
regulators, we expect that less off-balance-sheet financing will occur in the future.17
Evolving Issue
Off-and-On Reporting
The off-balance-sheet world is slowly but surely becoming more on-balance-sheet. New rules on
guarantees and consolidation of SPEs are doing their part to increase the amount of debt
reported on company statements of financial position. See footnote 16 for a discussion of the
IASB’s consolidation guidance.
In addition, companies must disclose off-balance-sheet arrangements and contractual obligations
that currently have, or are reasonably likely to have, a material future effect on the companies’
financial condition. Presented below is Novartis Group’s (CHE) tabular disclosure of its
contractual obligations. Because Novartis lists its securities in the United States, it is subject to
U.S. SEC rules.
Novartis Group
Contractual Obligations
The following table summarizes the Group’s contractual obligations and other commercial
commitments as well as the effect these obligations and commitments are expected to have on
the Group’s liquidity and cash flow in future periods:
Payments due by period
Less After
than 2–3 4–5 5
(in USD millions) Total 1 year years years years
Non-current financial debt, including current
portion 25,660 3,190 4,117 4,863 13,490
Interest on non-current financial debt, including
current portion 5,994 572 892 775 3,755
Operating leases 3,612 372 500 377 2,363
Unfunded pensions and other post-employment
benefit plans 2,094 122 254 266 1,452
Research and development potential milestone
commitments 4,417 228 1,632 1,663 894
Property, plant and equipment purchase
commitments 289 280 9
Total contractual cash obligations 42,066 4,764 7,404 7,944 21,954
The Group intends to fund the R&D and purchase commitments with internally generated
resources.
Enron’s (USA) abuse of off-balance-sheet financing to hide debt was shocking and
inappropriate. One silver lining in the Enron debacle, however, is that the standard-setting bodies
are now providing increased guidance on companies’ reporting of contractual obligations. We
believe the U.S. SEC rule, which requires companies to report their obligations over a period of
time, will be extremely useful to the investment community.
Presentation of Non-Current Liabilities

Companies that have large amounts and numerous issues of non-current liabilities frequently report
only one amount in the statement of financial position, supported with comments and schedules in
the accompanying notes. Long-term debt that matures within one year should be reported as a
current liability. If the company plans to refinance debt, convert it into shares, or retire it from a bond
retirement fund, it should continue to report the debt as non-current if the refinancing agreement is
completed by the end of the period. [10]
Note 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. Companies should show any assets pledged as security for the debt in the assets
section of the statement of financial position. The fair value of the long-term debt should also be
disclosed. Finally, companies must disclose future payments for sinking fund requirements and
maturity amounts of long-term debt during each of the next five years. These disclosures aid financial
statement users in evaluating the amounts and timing of future cash flows. Illustration 14.25
shows an example of the type of information provided for Novartis Group.
Novartis Group
(in millions)
Dec. 31, 2018 Dec. 31, 2017

Total current assets $ 35,563 $ 28,208
Non-current liabilities
Financial debts 22,470 23,224
Deferred tax liabilities 7,475 5,168
Provisions and other non-current liabilities 7,319 7,057
Total non-current liabilities 37,264 35,449
Current liabilities
Trade payables 5,556 5,169
Financial debts and derivative financial instruments 9,678 5,308
Current income tax liabilities 2,038 1,723
Provisions and other current liabilities 12,335 11,203
Total current liabilities 29,607 23,403
Total liabilities $66,871 $58,852
19. Non-Current Financial Debt
2018 2017
Straight bonds $ 25,283 $ 22,957
Liabilities to banks and other financial
institutions1 285 539
Finance lease obligations 92 87
Total, including current portion of
non-current financial debt 25,660 23,583
Less current portion of non-current
financial debt −3,190 −359
Total non-current financial debts $22,470 $23,244
1Average interest rate 0.3% (2017: 0.3%)
2018 2017
Breakdown by maturity 2018 $ 359
2019 $ 3,190 3,173
2020 2,006 1,997
2021 2,111 2,194
2022 2,585 2,485
2023 2,278 1,480
After 11,895
2023 13,490
Novartis Group
(in millions)
Total $25,660 $23,583

2018 2017
Breakdown by currency USD $ 15,964 $ 15,945
EUR 8,028 5,695
JPY 272 533
CHF 1,396 1,410
Total $25,660 $23,583
2018 2018 2017 2017
Balance Fair Balance Fair
Fair value comparison sheet values sheet values
Straight bonds $ 25,283 $25,438 $22,957 $23,885
Others 377 377 626 626
Total $25,660 $25,815 $23,583 $24,511
Collateralized non-current financial debt and 2018 2017
pledged assets USD millions USD millions
Total net book value of property, plant & equipment pledged
as collateral for non-current financial debt $96 $84
The Group’s collateralized non-current financial debt consists of loan facilities at usual market
conditions.
The percentage of fixed rate financial debt to total financial debt was 80% at December 31, 2018,
and December 31, 2017.
Financial debts, including current financial debts, contain only general default covenants. The
Group is in compliance with these covenants.
The average interest rate on total financial debt in 2018 was 2.7% (2017: 2.6%).
ILLUSTRATION 14.25 Long-Term Debt Disclosure
Analysis of Non-Current Liabilities

Long-term creditors and shareholders are interested in a company’s long-run solvency, particularly its
ability to pay interest as it comes due and to repay the face value of the debt at maturity. Debt to assets
and times interest earned are two ratios that provide information about debt-paying ability and long-
run solvency.
Debt to Assets Ratio

The debt to assets ratio measures the percentage of the total assets provided by creditors. To
compute it, divide total debt (both current and non-current liabilities) by total assets, as Illustration
14.26 shows.
Total Liabilities
Debt to Assets =
Total Assets
ILLUSTRATION 14.26 Computation of Debt to Assets Ratio

The higher the percentage of total liabilities to total assets, the greater the risk that the company may
be unable to meet its maturing obligations.
Times Interest Earned

The times interest earned ratio indicates the company’s ability to meet interest payments as they
come due. As shown in Illustration 14.27, it is computed by dividing the sum of net income, interest
expense, and income tax expense by interest expense.
Net Income + Interest Expense + Income Tax Expense
Times Interest Earned =
Interest Expense
ILLUSTRATION 14.27 Computation of Times Interest Earned

To illustrate these ratios, we use data from Novartis’s 2018 annual report. Novartis has total
liabilities of $66,871 million, total assets of $145,563 million, interest expense of $957 million, income
taxes of $1,221 million, and net income of $12,614 million. We compute Novartis’s debt to assets and
times interest earned ratios as shown in Illustration 14.28.
$66,871
Debt to assets = = 46%
$145,563
$12,614 + $957 + $1,221

Times interest earned = = 15.5 times
$957
ILLUSTRATION 14.28 Computation of Long-Term Debt Ratios for Novartis

Even though Novartis has a relatively high debt to assets ratio of 46 percent, its high interest coverage
of 15.5 times indicates it can meet its interest payments as they come due.
Review and Practice

Key Terms Review
amortization
bearer (coupon) bonds
bond discount
bond indenture
bond premium
callable bonds
carrying value
commodity-backed bonds
convertible bonds
debenture bonds
debt to assets ratio
deep-discount (zero-interest debenture) bonds
effective-interest method
effective yield or market rate
extinguishment of debt
face, par, principal, or maturity value
fair value option
imputation
imputed interest rate
income bonds
long-term debt
long-term notes payable
mortgage note payable
off-balance-sheet financing
refunding
registered bonds
revenue bonds
secured bonds
serial bonds
special purpose entity (SPE)
stated, coupon, or nominal rate
substantial modification (n)
term bonds
times interest earned
zero-interest debenture bonds
Learning Objectives Review
1 Describe the nature of bonds and indicate the accounting for bond issuances.
Incurring long-term debt is often a formal procedure. Companies usually require approval by the
board of directors and the shareholders before they can issue bonds or can make other long-term debt
arrangements. Generally, long-term debt has various covenants or restrictions. The covenants and
other terms of the agreement between the borrower and the lender are stated in the bond indenture or
note agreement.
Various types of bond issues are (1) secured and unsecured bonds; (2) term, serial, and callable
bonds; (3) convertible, commodity-backed, and deep-discount bonds; (4) registered and bearer
(coupon) bonds; and (5) income and revenue bonds. The variety in the types of bonds results from
attempts to attract capital from different investors and risk-takers and to satisfy the cash flow needs of
the issuers.
The investment community values a bond at the present value of its future cash flows,
which consist of interest and principal. The rate used to compute the present value of these cash
flows is the interest rate that provides an acceptable return on an investment commensurate with the
issuer’s risk characteristics. The interest rate written in the terms of the bond indenture and ordinarily
appearing on the bond certificate is the stated, coupon, or nominal rate. The issuer of the bonds sets
the rate and expresses it as a percentage of the face value (also called the par value, principal amount,
or maturity value) of the bonds. If the rate employed by the buyers differs from the stated rate, the
present value of the bonds computed by the buyers will differ from the face value of the bonds. The
difference between the face value and the present value of the bonds is either a discount or a
premium.
The discount (premium) is amortized and charged (credited) to interest expense over the
life of the bonds. Amortization of a discount increases bond interest expense, and amortization of a
premium decreases bond interest expense. The profession’s preferred procedure for amortization of a
discount or premium is the effective-interest method. Under the effective-interest method, (1)
bond interest expense is computed by multiplying the carrying value of the bonds at the beginning of
the period by the effective-interest rate; then, (2) the bond discount or premium amortization is
determined by comparing the bond interest expense with the interest to be paid.
2 Explain the accounting for long-term notes payable.
Accounting procedures for notes and bonds are similar. Like a bond, a note is valued at the present
value of its expected future interest and principal cash flows, with any discount or premium being
similarly amortized over the life of the note. Whenever the face amount of the note does not
reasonably represent the present value of the consideration in the exchange, a company must evaluate
the entire arrangement in order to properly record the exchange and the subsequent interest.
3 Explain the accounting for the extinguishment of non-current liabilities.
Non-current liabilities, such as bonds and notes payable, may be extinguished by (1) paying cash, (2)
transferring non-cash assets and/or granting of an equity interest, and (3) modification of terms. At
the time of extinguishment, any unamortized premium or discount must be amortized up to the
reacquisition date. The reacquisition price is the amount paid on extinguishment or redemption
before maturity, including any call premium and expense of reacquisition. On any specified date, the
carrying amount of the debt is the amount payable at maturity, adjusted for unamortized premium or
discount. Any excess of the carrying amount over the reacquisition price is a gain from
extinguishment. The excess of the reacquisition price over the carrying amount is a loss from
extinguishment. Gains and losses on extinguishments are recognized currently in income. When debt
is extinguished by transfer of non-cash assets or granting of equity interest, debtors record losses and
gains on settlements based on fair values. The accounting for debt extinguished with modification is
similar to that for other extinguishments. That is, the original obligation is extinguished, the new
payable is recorded at fair value, and a gain or loss is recognized for the difference in the fair value of
the new obligation and the carrying value of the old obligation.
4 Indicate how to present and analyze non-current liabilities.
Fair value option. Companies have the option to record fair value in their accounts for most
financial assets and liabilities, including non-current liabilities. Fair value measurement for financial
instruments, including financial liabilities, provides more relevant and understandable information
than amortized cost. If companies choose the fair value option, non-current liabilities such as bonds
and notes payable are recorded at fair value, with unrealized holding gains or losses reported as part of
net income. An unrealized holding gain or loss is the net change in the fair value of the liability from
one period to another, exclusive of interest expense recognized but not recorded.
Off-balance-sheet financing arrangements. Off-balance-sheet financing is an attempt to borrow
funds in such a way as to prevent recording obligations. Examples of off-balance-sheet arrangements
are (1) non-consolidated subsidiaries and (2) special purpose entities.
Presentation. Companies that have large amounts and numerous issues of non-current liabilities
frequently report only one amount in the statement of financial position and support this with
comments and schedules in the accompanying notes. Any assets pledged as security for the debt
should be shown in the assets section of the statement of financial position. Long-term debt that
matures within one year should be reported as a current liability, unless retirement is to be
accomplished with other than current assets. If a company plans to refinance the debt, convert it into
shares, or retire it from a bond retirement fund, it should continue to report it as non-current, as long
as the refinancing is completed by the end of the period. Disclosure is required of future payments for
sinking fund requirements and maturity amounts of long-term debt during each of the next five years.
Analysis. Debt to assets and times interest earned are two ratios that provide information about a
company’s debt-paying ability and long-run solvency.
Enhanced Review and Practice

Go online for multiple-choice questions with solutions, review exercises with solutions, and a
full glossary of all key terms.
Practice Problem
Consider the following independent situations:
a. On March 1, 2022, Heide AG issued at 103 plus accrued interest €3,000,000, 9% bonds. The
bonds are dated January 1, 2022, and pay interest semiannually on July 1 and January 1. In
addition, Heide incurred €27,000 of bond issuance costs. Compute the net amount of cash
received by Heide as a result of the issuance of these bonds.
b. On January 1, 2022, Reymont SA issued 9% bonds with a face value of €500,000 for €469,280
to yield 10%. The bonds are dated January 1, 2022, and pay interest annually. What is the
amount of discount on the issue date? Prepare the journal entry to record interest expense on
December 31, 2022.
c. Czeslaw Building Co. has a number of long-term bonds outstanding at December 31, 2022.
These long-term bonds have the following sinking fund requirements and maturities for the
next 6 years.
Sinking Fund Maturities

2023 €300,000 €100,000
2024 100,000 250,000
2025 100,000 100,000
2026 200,000 —
2027 200,000 150,000
2028 200,000 100,000
Indicate how this information should be reported in the financial statements at December 31, 2022.
Instructions
Prepare responses for each item above.
Solution
a. Heide AG
Selling price of the bonds (€3,000,000 × 1.03) €3,090,000
Accrued interest from January 1 to February 28, 2022 (€3,000,000 × .09 × 2/ )
12 45,000
Total cash received from issuance of the bonds 3,135,000
Less: Bond issuance costs 27,000
Net amount of cash received €3,108,000
b. Reymont SA
Face value of bonds € 500,000
Issue price (469,280)
Bond discount on issue date € 30,720
December 31, 2022

Interest Expense (€469,280 × .10) 46,928
Bonds Payable (€46,928 − €45,000) 1,928
Interest Payable (€500,000 × .09) 45,000
c. Czeslaw Building Co.
Maturities and sinking fund requirements on long-term debt for each of the next five years are as
follows.
2023 €400,000 2026 €200,000
2024 350,000 2027 350,000
2025 200,000
Exercises, Problems, Problem Solution Walkthrough Videos, Data Analytics Activities, and many
more assessment tools and resources are available for practice in Wiley’s online courseware.
(Unless instructed otherwise, round all answers to the nearest whole currency unit.)
Questions
1. (a) From what sources might a company obtain funds through long-term debt? (b) What is a bond
indenture? What does it contain? (c) What is a mortgage?
2. Novartis Group (CHE) has issued various types of bonds, such as term bonds, income bonds, and
debentures. Differentiate between term bonds, mortgage bonds, collateral trust bonds, debenture
bonds, income bonds, callable bonds, registered bonds, bearer or coupon bonds, convertible bonds,
commodity-backed bonds, and deep-discount bonds.
3. Distinguish between the following interest rates for bonds payable:
a. Yield rate.
b. Nominal rate.
c. Stated rate.
d. Market rate.
e. Effective rate.
4. Distinguish between the following values relative to bonds payable:
a. Maturity value.
b. Face value.
c. Market (fair) value.
d. Par value.
5. Under what conditions of bond issuance does a discount on bonds payable arise? Under what
conditions of bond issuance does a premium on bonds payable arise?
6. Briefly explain how bond premium or discount affects interest expense over the life of a bond.
7. What is the required method of amortizing discount and premium on bonds payable? Explain the
procedures.
8. Zopf NV sells its bonds at a premium and applies the effective-interest method in amortizing the
premium. Will the annual interest expense increase or decrease over the life of the bonds? Explain.
9. Vodafone (GBR) recently issued debt. How should the costs of issuing these bonds be accounted
for?
10. Will the amortization of a bond discount increase or decrease bond interest expense? Explain.
11. What is done to record properly a transaction involving the issuance of a non-interest-bearing
long-term note in exchange for property?
12. How is the present value of a non-interest-bearing note computed?
13. When is the stated interest rate of a debt instrument presumed to be fair?
14. What are the considerations in imputing an appropriate interest rate?
15. Differentiate between a fixed-rate mortgage and a variable-rate mortgage.
16. Identify the situations under which debt is extinguished.
17. What is the “call” feature of a bond issue? How does the call feature affect the amortization of
bond premium or discount?
18. Why would a company wish to reduce its bond indebtedness before its bonds reach maturity?
Indicate how this can be done and the correct accounting treatment for such a transaction.
19. What are the general rules for measuring a gain or a loss by a debtor in a debt extinguishment?
20.
a. In a debt modification situation, why might the creditor grant concessions to the debtor?
b. What type of concessions might a creditor grant the debtor in a debt modification situation?
21. What are the general rules for measuring and recognizing gain or loss by a debt extinguishment
with modification?
22. What is the fair value option? Briefly describe the controversy of applying the fair value option to
financial liabilities.
23. Pierre SA has a 12% note payable with a carrying value of €20,000. Pierre applies the fair value
option to this note; given a decrease in market interest rates, the fair value of the note is €22,600.
Prepare the entry to record the fair value option for this note.
24. What disclosures are required relative to long-term debt and sinking fund requirements?
25. What is off-balance-sheet financing? Why might a company be interested in using off-balance-
sheet financing?
26. What are some forms of off-balance-sheet financing?
27. Explain how a non-consolidated subsidiary can be a form of off-balance-sheet financing.
Brief Exercises
BE14.1 (LO 1) Whiteside Ltd. issues ¥500,000 of 9% bonds, due in 10 years, with interest payable
semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of
the bonds.
BE14.2 (LO 1) The Colson Company issued €300,000 of 10% bonds on January 1, 2022. The bonds
are due January 1, 2027, with interest payable each July 1 and January 1. The bonds are issued at face
value. Prepare Colson’s journal entries for (a) the January issuance, (b) the July 1 interest payment,
and (c) the December 31 adjusting entry.
BE14.3 (LO 1) Assume the bonds in BE14.2 were issued at 108.11 to yield 8%. Prepare the journal
entries for (a) January 1, (b) July 1, and (c) December 31.
BE14.4 (LO 1) Assume the bonds in BE14.2 were issued at 92.6393 to yield 12%. Prepare the journal
entries for (a) January 1, (b) July 1, and (c) December 31.
BE14.5 (LO 1) Devers plc issued £400,000 of 6% bonds on May 1, 2022. The bonds were dated
January 1, 2022, and mature January 1, 2024, with interest payable July 1 and January 1. The bonds
were issued at face value plus accrued interest. Prepare Devers’ journal entries for (a) the May 1
issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry.
BE14.6 (LO 1) On January 1, 2022, JWS Corporation issued $600,000 of 7% bonds, due in 10 years.
The bonds were issued for $559,224, and pay interest each July 1 and January 1. Prepare the
company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the
December 31 adjusting entry. Assume an effective-interest rate of 8%.
BE14.7 (LO 1) Assume the bonds in BE14.6 were issued for $644,636 with an effective-interest rate
of 6%. Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest
payment, and (c) the December 31 adjusting entry.
BE14.8 (LO 1) Tan Ltd. issued HK$600,000,000 of 7% bonds on November 1, 2022, for
HK$644,636,000. The bonds were dated November 1, 2022, and mature in 10 years, with interest
payable each May 1 and November 1. The effective-interest rate is 6%. Prepare Tan’s December 31,
2022, adjusting entry.
BE14.9 (LO 2) Coldwell AG issued a €100,000, 4-year, 10% note at face value to Flint Hills Bank on
January 1, 2022, and received €100,000 cash. The note requires annual interest payments each
December 31. Prepare Coldwell’s journal entries to record (a) the issuance of the note and (b) the
December 31 interest payment.
BE14.10 (LO 2) Samson plc issued a 4-year, £75,000, zero-interest-bearing note to Brown Ltd. on
January 1, 2022, and received cash of £47,664. The implicit interest rate is 12%. Prepare Samson’s
journal entries for (a) the January 1 issuance and (b) the December 31 recognition of interest.
BE14.11 (LO 2) McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company
on January 1, 2022, and received a computer that normally sells for $31,495. The note requires annual
interest payments each December 31. The market rate of interest for a note of similar risk is 12%.
Prepare McCormick’s journal entries for (a) the January 1 issuance and (b) the December 31 interest.
BE14.12 (LO 2) Shlee SA issued a 4-year, €60,000, zero-interest-bearing note to Garcia Company on
January 1, 2022, and received cash of €60,000. In addition, Shlee agreed to sell merchandise to Garcia
at an amount less than regular selling price over the 4-year period. The market rate of interest for
similar notes is 12%. Prepare Shlee’s January 1 journal entry.
BE14.13 (LO 3) On January 1, 2022, Henderson Corporation retired $500,000 of bonds at 99. At the
time of retirement, the unamortized premium was $15,000. Prepare Henderson’s journal entry to
record the reacquisition of the bonds.
BE14.14 (LO 3) Refer to the note issued by Coldwell AG in BE14.9. During 2022, Coldwell
experiences financial difficulties. On January 1, 2023, Coldwell negotiates a settlement of the note by
issuing to Flint Hills Bank 20,000 €1 par Coldwell ordinary shares. The ordinary shares have a market
price of €4.75 per share on the date of the settlement. Prepare Coldwell’s entries to settle this note.
BE14.15 (LO 3) Refer to the note issued by Coldwell AG in BE14.9. During 2022, Coldwell
experiences financial difficulties. On January 1, 2023, Coldwell negotiates a modification of the terms
of the note. Under the modification, Flint Hills Bank agrees to reduce the face value of the note to
€90,000 and to extend the maturity date to January 1, 2027. Annual interest payments on December
31 will be made at a rate of 8%. Coldwell’s market interest rate at the time of the modification is 12%.
Prepare Coldwell’s entries for (a) the modification on January 1, 2023, and (b) the first interest
payment date on December 31, 2023.
BE14.16 (LO 4) Shonen Knife Ltd. has elected to use the fair value option for one of its notes
payable. The note was issued at an effective rate of 11% and has a carrying value of HK$16,000. At
year-end, Shonen Knife’s borrowing rate has declined; the fair value of the note payable is now
HK$17,500. (a) Determine the unrealized gain or loss on the note and (b) prepare the entry to record
any unrealized gain or loss, assuming that the change in value was due to general market conditions.
BE14.17 (LO 4) At December 31, 2022, Hyasaki Corporation has the following account balances:
Bonds payable, due January 1, 2030 $1,912,000
Interest payable 80,000
Show how the above accounts should be presented on the December 31, 2022, statement of financial
position, including the proper classifications.
Exercises
E14.1 (LO 1) (Classification of Liabilities) Presented below are various account balances.
a. Bank loans payable of a winery, due March 10, 2025. (The product requires aging for 5 years
before sale.)
b. Serial bonds payable, €1,000,000, of which €250,000 are due each July 31.
c. Amounts withheld from employees’ wages for income taxes.
d. Notes payable due January 15, 2024.
e. Credit balances in customers’ accounts arising from returns and allowances after collection in full
of account.
f. Bonds payable of €2,000,000 maturing June 30, 2023.
g. Overdraft of €1,000 in a bank account. (No other balances are carried at this bank.)
h. Deposits made by customers who have ordered goods.
Instructions
Indicate whether each of the items above should be classified on December 31, 2022, as a current
liability, a non-current liability, or under some other classification. Consider each one independently
from all others; that is, do not assume that all of them relate to one particular business. If the
classification of some of the items is doubtful, explain why in each case.
E14.2 (LO 1, 2) (Classification) The following items are found in the financial statements.
a. Interest expense (credit balance).

b. Bond issue costs.
c. Gain on repurchase of debt.
d. Mortgage payable (payable in equal amounts over next 3 years).
e. Debenture bonds payable (maturing in 5 years).
f. Notes payable (due in 4 years).
g. Income bonds payable (due in 3 years).
Instructions
Indicate how each of these items should be classified in the financial statements.
E14.3 (LO 1) (Entries for Bond Transactions) Presented below are two independent situations.
1. On January 1, 2022, Divac SA issued €300,000 of 9%, 10-year bonds at par. Interest is payable
quarterly on April 1, July 1, October 1, and January 1.
2. On June 1, 2022, Verbitsky AG issued €200,000 of 12%, 10-year bonds dated January 1 at par plus
accrued interest. Interest is payable semiannually on July 1 and January 1.
Instructions
For each of these two independent situations, prepare journal entries to record the following.
a. The issuance of the bonds.

b. The payment of interest on July 1.
c. The accrual of interest on December 31.
E14.4 (LO 1) (Entries for Bond Transactions) Foreman Cleaners issued €800,000 of 10%, 20-
year bonds on January 1, 2022, at 119.792 to yield 8%. Interest is payable semiannually on July 1 and
January 1.
Instructions
Prepare the journal entries to record the following.

b. The payment of interest and the related amortization on July 1, 2022.
c. The accrual of interest and the related amortization on December 31, 2022.
E14.5 (LO 1) (Entries for Bond Transactions) Assume the same information as in E14.4, except
that the bonds were issued at 84.95 to yield 12%.
Instructions
Prepare the journal entries to record the following. (Round to the nearest euro.)

b. The payment of interest and related amortization on July 1, 2022.
c. The accrual of interest and the related amortization on December 31, 2022.
E14.6 (LO 1) (Amortization Schedule) Spencer plc sells 10% bonds having a maturity value of
£3,000,000 for £2,783,724. The bonds are dated January 1, 2022, and mature January 1, 2027. Interest
is payable annually on January 1.
Instructions
Set up a schedule of interest expense and discount amortization. (Hint: The effective-interest rate
must be computed.)
E14.7 (LO 1) (Determine Proper Amounts in Account Balances) Presented below
are three independent situations.
Instructions
a. McEntire Co. sold $2,500,000 of 11%, 10-year bonds at 106.231 to yield 10% on January 1, 2022.
The bonds were dated January 1, 2022, and pay interest on July 1 and January 1. Determine the
amount of interest expense to be reported on July 1, 2022, and December 31, 2022.
b. Cheriel Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2022, for $562,500. This price
provided a yield of 10% on the bonds. Interest is payable semiannually on December 31 and June
30. Determine the amount of interest expense to record if financial statements are issued on
October 31, 2022.
c. On October 1, 2022, Chinook Company sold 12% bonds having a maturity value of $800,000 for
$853,382 plus accrued interest, which provides the bondholders with a 10% yield. The bonds are
dated January 1, 2022, and mature January 1, 2027, with interest payable December 31 of each
year. Prepare the journal entries at the date of the bond issuance and for the first interest
payment.
E14.8 (LO 1) (Entries and Questions for Bond Transactions) On June 30, 2021,
Macias SA issued R$5,000,000 face value of 13%, 20-year bonds at R$5,376,150 to yield 12%. The
bonds pay semiannual interest on June 30 and December 31.
Instructions
a. Prepare the journal entries to record the following transactions.

1. The issuance of the bonds on June 30, 2021.
2. The payment of interest and the amortization of the premium on December 31, 2021.
3. The payment of interest and the amortization of the premium on June 30, 2022.
4. The payment of interest and the amortization of the premium on December 31, 2022.
b. Show the proper statement of financial position presentation for the liability for bonds payable on
the December 31, 2022, statement of financial position.
c. Provide the answers to the following questions.
1. What amount of interest expense is reported for 2022?
2. Determine the total cost of borrowing over the life of the bond.
E14.9 (LO 1) (Entries for Bond Transactions) On January 1, 2022, Osborn plc sold 12% bonds
having a maturity value of £800,000 for £860,651.79, which provides the bondholders with a 10%
yield. The bonds are dated January 1, 2022, and mature January 1, 2027, with interest payable
December 31 of each year.
Instructions
a. Prepare the journal entry at the date of the bond issuance.

b. Prepare a schedule of interest expense and bond amortization for 2022–2024.
c. Prepare the journal entry to record the interest payment and the amortization for 2022.
d. Prepare the journal entry to record the interest payment and the amortization for 2024.
E14.10 (LO 1) (Information Related to Various Bond Issues) Pawnee Inc. has issued three
types of debt on January 1, 2022, the start of the company’s fiscal year.
a. $10 million, 10-year, 13% unsecured bonds, interest payable quarterly. Bonds were priced to yield
12%.
b. $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year.
c. $15 million, 10-year, 10% mortgage bonds, interest payable annually to yield 12%.
Instructions
Prepare a schedule that identifies the following items for each bond: (1) maturity value, (2) number of
interest periods over life of bond, (3) stated rate per each interest period, (4) effective-interest rate per
each interest period, (5) payment amount per period, and (6) present value of bonds at date of issue.
E14.11 (LO 2) (Entries for Zero-Interest-Bearing Notes) On January 1, 2022, McLean AG

makes the two following acquisitions.
1. Purchases land having a fair value of €300,000 by issuing a 5-year, zero-interest-bearing

promissory note in the face amount of €505,518.
2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of
€400,000 (interest payable annually).
The company has to pay 11% interest for funds from its bank.
Instructions
a. Record the two journal entries that should be recorded by McLean AG for the two purchases on
January 1, 2022.
b. Record the interest at the end of the first year on both notes.
E14.12 (LO 2) (Imputation of Interest) The following are two independent situations.
Instructions
a. On January 1, 2022, Spartan Inc. purchased land that had an assessed value of $390,000 at the
time of purchase. A $600,000, zero-interest-bearing note due January 1, 2025, was given in
exchange. There was no established exchange price for the land, nor a ready market price for the
note. The interest rate charged on a note of this type is 12%. Determine at what amount the land
should be recorded at January 1, 2022, and the interest expense to be reported in 2022 related to
this transaction.
b. On January 1, 2022, Geimer Furniture Co. borrowed $4,000,000 (face value) from Aurora Co., a
major customer, through a zero-interest-bearing note due in 4 years. Because the note was zero-
interest-bearing, Geimer Furniture agreed to sell furniture to this customer at lower than market
price. A 10% rate of interest is normally charged on this type of loan. Prepare the journal entry to
record this transaction and determine the amount of interest expense to report for 2022.
E14.13 (LO 2) (Imputation of Interest with Right) On January 1, 2022, Durdil A.Ş. borrowed
and received 500,000 from a major customer evidenced by a zero-interest-bearing note due in 3
years. As consideration for the zero-interest-bearing feature, Durdil agrees to supply the customer’s
inventory needs for the loan period at lower than the market price. The appropriate rate at which to
impute interest is 8%.
Instructions
a. Prepare the journal entry to record the initial transaction on January 1, 2022.
b. Prepare the journal entry to record any adjusting entries needed at December 31, 2022. Assume
that the sales of Durdil’s product to this customer occur evenly over the 3-year period.
E14.14 (LO 1, 3) (Entry for Retirement of Bond; Bond Issue Costs) On January 2, 2019,
Prebish Corporation issued $1,500,000 of 10% bonds to yield 11% due December 31, 2028. Interest on
the bonds is payable annually each December 31. The bonds are callable at 101 (i.e., at 101% of face
amount), and on January 2, 2022, Prebish called $1,000,000 face amount of the bonds and retired
them.
Instructions
a. Determine the price of the Prebish bonds when issued on January 2, 2019.
b. Prepare an amortization schedule for 2019–2023 for the bonds.
c. Ignoring income taxes, compute the amount of loss, if any, to be recognized by Prebish as a result
of retiring the $1,000,000 of bonds on January 2, 2022, and prepare the journal entry to record
the retirement.
E14.15 (LO 1, 3) (Entries for Retirement and Issuance of Bonds) On June 30, 2014,
Mendenhal plc issued 8% bonds with a par value of £600,000 due in 20 years. They were issued at
82.8414 to yield 10% and were callable at 104 at any date after June 30, 2022. Because of lower
interest rates and a significant change in the company’s credit rating, it was decided to call the entire
issue on June 30, 2023, and to issue new bonds. New 6% bonds were sold in the amount of £800,000
at 112.5513 to yield 5%; they mature in 20 years. Interest payment dates are December 31 and June 30
for both old and new bonds.
Instructions
a. Prepare journal entries to record the retirement of the old issue and the sale of the new issue on
June 30, 2023. Unamortized discount is £78,979.
b. Prepare the entry required on December 31, 2023, to record the payment of the first 6 months’
interest and the amortization of premium on the bonds.
E14.16 (LO 1, 3) (Entries for Retirement and Issuance of Bonds) Kobiachi Group had bonds
outstanding with a maturity value of ¥5,000,000. On April 30, 2023, when these bonds had an
unamortized discount of ¥100,000, they were called in at 104. To pay for these bonds, Kobiachi had
issued other bonds a month earlier bearing a lower interest rate. The newly issued bonds had a life of
10 years. The new bonds were issued at 103 (face value ¥5,000,000).
Instructions
Ignoring interest, compute the gain or loss and record this refunding transaction.
E14.17 (LO 3) (Settlement of Debt) Strickland Company owes $200,000 plus $18,000 of accrued
interest to Moran State Bank. The debt is a 10-year, 10% note. During 2022, Strickland’s business
deteriorated due to a faltering regional economy. On December 31, 2022, Moran State Bank agrees to
accept an old machine and cancel the entire debt. The machine has a cost of $390,000, accumulated
depreciation of $221,000, and a fair value of $180,000.
Instructions
a. Prepare journal entries for Strickland Company to record this debt settlement.
b. How should Strickland report the gain or loss on the disposition of machine and on restructuring
of debt in its 2022 income statement?
c. Assume that, instead of transferring the machine, Strickland decides to grant 15,000 of its
ordinary shares ($10 par), which have a fair value of $180,000, in full settlement of the loan
obligation. Prepare the entries to record the transaction.
E14.18 (LO 3) (Loan Modification) On December 31, 2022, Sterling Bank enters into a debt
restructuring agreement with Barkley plc, which is now experiencing financial trouble. The bank
agrees to restructure a 12%, issued at par, £3,000,000 note receivable by the following modifications:
1. Reducing the principal obligation from £3,000,000 to £2,400,000.

2. Extending the maturity date from December 31, 2022, to January 1, 2026.
3. Reducing the interest rate from 12% to 10%. Barkley’s market rate of interest is 15%.
Barkley pays interest at the end of each year. On January 1, 2026, Barkley pays £2,400,000 in cash to
Sterling Bank.
Instructions
a. Can Barkley record a gain under the term modification mentioned above? Explain.
b. Prepare the amortization schedule of the note for Barkley after the debt modification.
c. Prepare the interest payment entry for Barkley on December 31, 2024.
d. What entry should Barkley make on January 1, 2026?
E14.19 (LO 3) (Loan Modification) Use the same information as in E14.18 except that Sterling
Bank reduced the principal to £1,900,000 rather than £2,400,000. On January 1, 2026, Barkley pays
£1,900,000 in cash to Sterling Bank for the principal.
Instructions
a. Prepare the journal entries to record the loan modification for Barkley.
b. Prepare the amortization schedule of the note for Barkley after the debt modification.
c. Prepare the interest payment entries for Barkley on December 31 of 2023, 2024, and 2025.
d. What entry should Barkley make on January 1, 2026?
E14.20 (LO 3) (Entries for Settlement of Debt) Consider the following independent situations.
Instructions
a. Gottlieb Stores owes €199,800 to Ceballos SpA. The debt is a 10-year, 11% note. Because Gottlieb
is in financial trouble, Ceballos agrees to accept some land and cancel the entire debt. The land
has a book value of €90,000 and a fair value of €140,000. Prepare the journal entry on Gottlieb’s
books for debt settlement.
b. Vargo Corp. owes $270,000 to First Trust. The debt is a 10-year, 12% note due December 31, 2022.
Because Vargo Corp. is in financial trouble, First Trust agrees to extend the maturity date to
December 31, 2024, reduce the principal to $220,000, and reduce the interest rate to 5%, payable
annually on December 31. Vargo’s market rate of interest is 8%. Prepare the journal entries on
Vargo’s books on December 31, 2022, 2023, and 2024.
E14.21 (LO 4) (Fair Value Option) Fallen AG commonly issues long-term notes payable to its
various lenders. Fallen has had a pretty good credit rating, such that its effective borrowing rate is
quite low (less than 8% on an annual basis). Fallen has elected to use the fair value option for the
long-term notes issued to Barclay’s Bank and has the following data related to the carrying and fair
value for these notes. (Assume that changes in fair value are due to general market interest rate
changes).
Carrying Value Fair Value
December 31, 2022 €54,000 €54,000
December 31, 2023 44,000 42,500
December 31, 2024 36,000 38,000
Instructions
a. Prepare the journal entry at December 31 (Fallen’s year-end) for 2022, 2023, and 2024, to record
the fair value option for these notes.
b. At what amount will the note be reported on Fallen’s 2023 statement of financial position?
c. What is the effect of recording the fair value option on these notes on Fallen’s 2024 income?
d. Assuming that general market interest rates have been stable over the period, do the fair value
data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2024?
Explain.
e. Assuming the conditions that exist in (d), what is the effect of recording the fair value option on
these notes in Fallen’s income statement in 2022, 2023, and 2024?
E14.22 (LO 4) (Long-Term Debt Disclosure) At December 31, 2022, Redmond Company has
outstanding three long-term debt issues. The first is a $2,000,000 note payable which matures June
30, 2025. The second is a $6,000,000 bond issue which matures September 30, 2026. The third is a
$12,500,000 sinking fund debenture with annual sinking fund payments of $2,500,000 in each of the
years 2024 through 2027.
Instructions
Prepare the required note disclosure for the long-term debt at December 31, 2022.
Problems
P14.1 (LO 1) (Analysis of Amortization Schedule and Interest Entries) The

following amortization and interest schedule reflects the issuance of 10-year bonds by Capulet SpA on
January 1, 2016, and the subsequent interest payments and charges. The company’s year-end is
December 31, and financial statements are prepared once yearly.
Amortization Schedule
Amount
Year Cash Interest Unamortized Book Value
1/1/2016 €5,651 € 94,349
2016 €11,000 €11,322 5,329 94,671
2017 11,000 11,361 4,968 95,032
2018 11,000 11,404 4,564 95,436
2019 11,000 11,452 4,112 95,888
2020 11,000 11,507 3,605 96,395
2021 11,000 11,567 3,038 96,962
2022 11,000 11,635 2,403 97,597
2023 11,000 11,712 1,691 98,309
2024 11,000 11,797 894 99,106
2025 11,000 11,894 100,000
Instructions
a. Indicate whether the bonds were issued at a premium or at a discount and how you can determine
this fact from the schedule.
b. Determine the stated interest rate and the effective-interest rate.
c. On the basis of the schedule, prepare the journal entry to record the issuance of the bonds on
January 1, 2016.
d. On the basis of the schedule, prepare the journal entry or entries to reflect the bond transactions
and accruals for 2016. (Interest is paid January 1.)
e. On the basis of the schedule, prepare the journal entry or entries to reflect the bond transactions
and accruals for 2023. Capulet does not use reversing entries.
P14.2 (LO 1, 3) (Issuance and Retirement of Bonds) Venzuela Co. is building a new hockey
arena at a cost of $2,500,000. It received a down payment of $500,000 from local businesses to
support the project and now needs to borrow $2,000,000 to complete the project. It decides to issue
$2,000,000 of 10.5%, 10-year bonds. These bonds were issued on January 1, 2021, and pay interest
annually on each January 1. The bonds yield 10%.
Instructions
a. Prepare the journal entry to record the issuance of the bonds on January 1, 2021.
b. Prepare a bond amortization schedule up to and including January 1, 2025.
c. Assume that on July 1, 2024, Venzuela Co. retires half of the bonds at a cost of $1,065,000 plus
accrued interest. Prepare the journal entry to record this retirement.
P14.3 (LO 1) (Negative Amortization) Good-Deal Auto developed a new sales gimmick to help sell
its inventory of new automobiles. Because many new car buyers need financing, Good-Deal offered a
low down payment and low car payments for the first year after purchase. It believes that this
promotion will bring in some new buyers.
On January 1, 2022, a customer purchased a new €33,000 automobile, making a down payment of
€1,000. The customer signed a note indicating that the annual rate of interest would be 8% and that
quarterly payments would be made over 3 years. For the first year, Good-Deal required a €400
quarterly payment to be made on April 1, July 1, October 1, and January 1, 2023. After this one-year
period, the customer was required to make regular quarterly payments that would pay off the loan as
of January 1, 2025.
Instructions
a. Prepare a note amortization schedule for the first year.

b. Indicate the amount the customer owes on the contract at the end of the first year.
c. Compute the amount of the new quarterly payments.
d. Prepare a note amortization schedule for these new payments for the next 2 years.
e. What do you think of the new sales promotion used by Good-Deal?
P14.4 (LO 1) (Effective-Interest Method) Samantha Cordelia, an intermediate accounting

student, is having difficulty amortizing bond premiums and discounts using the effective-interest
method. Furthermore, she cannot understand why IFRS requires that this method be used. She has
come to you with the following problem, looking for help.
On June 30, 2022, Hobart SA issued R$2,000,000 face value of 11%, 20-year bonds at R$2,171,600, a
yield of 10%. Hobart uses the effective-interest method to amortize bond premiums or discounts. The
bonds pay semiannual interest on June 30 and December 31.
Instructions
Prepare the amortization schedule for four periods. Using the data for illustrative purposes, write a
short memo (1–1.5 pages double-spaced) to Samantha, explaining what the effective-interest method
is, why it is preferable, and how it is computed. (Do not forget to include an amortization schedule,
referring to it whenever necessary.)
P14.5 (LO 2) (Entries for Zero-Interest-Bearing Note) On December 31, 2022, Faital plc
acquired a computer system from Plato Group by issuing a £600,000 zero-interest-bearing note,
payable in full on December 31, 2026. Faital’s credit rating permits it to borrow funds from its several
lines of credit at 10%. The computer is expected to have a 5-year life and a £70,000 residual value.
Instructions
a. Prepare the journal entry for the purchase on December 31, 2022.
b. Prepare any necessary adjusting entries relative to depreciation (use straight-line) and
amortization on December 31, 2023.
c. Prepare any necessary adjusting entries relative to depreciation and amortization on December
31, 2024.
P14.6 (LO 2) (Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis

Cosmetics Co. purchased machinery on December 31, 2021, paying $50,000 down and agreeing to pay
the balance in four equal installments of $40,000 payable each December 31. An assumed interest
rate of 8% is implicit in the purchase price.
Instructions
Prepare the journal entries that would be recorded for the purchase and for the payments and interest
on the following dates.
a. December 31, 2021.

b. December 31, 2022.
c. December 31, 2023.
d. December 31, 2024.
e. December 31, 2025.
P14.7 (LO 1, 3, 4) (Issuance and Retirement of Bonds; Income Statement Presentation)

Chen Ltd. issued its 9%, 25-year mortgage bonds in the principal amount of ¥30,000,000 on January
2, 2008, at a discount of ¥2,722,992 (effective rate of 10%). The indenture securing the issue provided
that the bonds could be called for redemption in total, but not in part, at any time before maturity at
104% of the principal amount. However, the indenture did not provide for any sinking fund.
On December 18, 2022, the company issued its 11%, 20-year debenture bonds in the principal amount
of ¥40,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on
January 2, 2023. The indenture securing the new issue did not provide for any sinking fund or for
retirement before maturity. The unamortized discount at retirement was ¥1,842,888.
Instructions
a. Prepare journal entries to record the issuance of the 11% bonds and the retirement of the 9%
bonds.
b. Indicate the income statement treatment of the gain or loss from retirement and the note
disclosure required.
P14.8 (LO 1, 3) (Comprehensive Bond Problem) In each of the following independent cases, the
company closes its books on December 31.
1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2022. The bonds pay interest on September
1 and March 1. The due date of the bonds is September 1, 2025. The bonds yield 12%. Give entries
through December 31, 2023.
2. Titania Co. sells $400,000 of 12% bonds on June 1, 2022. The bonds pay interest on December 1
and June 1. The due date of the bonds is June 1, 2026. The bonds yield 10%. On October 1, 2023,
Titania buys back $120,000 worth of bonds for $126,000 (includes accrued interest). Give entries
through December 1, 2024.
Instructions
For the two cases, prepare all of the relevant journal entries from the time of sale until the date
indicated. (Construct amortization tables where applicable.) Amortize premium or discount on
interest dates and at year-end. (Assume that no reversing entries were made; round to the nearest
dollar.)
P14.9 (LO 1, 3) (Issuance of Bonds Between Interest Dates, Retirement)

Presented below are selected transactions on the books of Simonson Foundry.
July Bonds payable with a par value of €900,000, which are dated January 1, 2022, are sold at
1, 112.290 plus accrued interest to yield 10%. They are coupon bonds, bear interest at 12%
2022 (payable annually at January 1), and mature January 1, 2032. (Use interest expense account for
accrued interest.)
Dec. Adjusting entries are made to record the accrued interest on the bonds, and the amortization of
31 the proper amount of premium.
Jan. Interest on the bonds is paid.
1,
2023
Jan. Bonds of par value of €360,000 are called at 102 and extinguished.
2
Dec. Adjusting entries are made to record the accrued interest on the bonds, and the proper amount
31 of premium amortized.
Instructions
Prepare journal entries for the transactions above.
P14.10 (LO 1, 3) (Entries for Life Cycle of Bonds) On April 1, 2022, Sarkar Sailboats sold 15,000
of its 11%, 15-year, R$1,000 face value bonds to yield 12%. Interest payment dates are April 1 and
October 1. On April 2, 2023, Sarkar took advantage of favorable prices of its shares to extinguish 6,000
of the bonds by issuing 200,000 of its R$10 par value ordinary shares. At this time, the accrued
interest was paid in cash. The company’s shares were selling for R$31 per share on April 2, 2023.
Instructions
Prepare the journal entries needed on the books of Sarkar to record the following.
a. April 1, 2022: issuance of the bonds.

b. October 1, 2022: payment of semiannual interest.
c. December 31, 2022: accrual of interest expense.
d. April 1, 2023: payment of semiannual interest.
e. April 2, 2023: extinguishment of 6,000 bonds. (No reversing entries made.)
P14.11 (LO 3) (Modification of Debt) Daniel Perkins is the sole shareholder of Perkins Inc., which
is currently under protection of the U.S. bankruptcy court. As a “debtor in possession,” he has
negotiated the following revised loan agreement with United Bank. Perkins Inc.’s $600,000, 12%, 10-
year note was refinanced with a $600,000, 5%, 10-year note. Perkins has a market rate of interest of
15%.
Instructions
a. What is the accounting nature of this transaction?

b. Prepare the journal entry to record this refinancing on the books of Perkins Inc.
P14.12 (LO 3) (Modification of Note under Different Circumstances) Halvor Corporation is

having financial difficulty and therefore has asked Frontenac National Bank to restructure its $5
million note outstanding. The present note has 3 years remaining and pays a current rate of interest of
10%. The present market rate for a loan of this nature is 12%. The note was issued at its face value.
Instructions
Presented below are three independent situations. Prepare the journal entry that Halvor would make
for each of these restructurings.
a. Frontenac National Bank agrees to take an equity interest in Halvor by accepting ordinary shares
valued at $3,700,000 in exchange for relinquishing its claim on this note. The ordinary shares
have a par value of $1,700,000.
b. Frontenac National Bank agrees to accept land in exchange for relinquishing its claim on this
note. The land has a book value of $3,250,000 and a fair value of $4,000,000.
c. Frontenac National Bank agrees to modify the terms of the note, indicating that Halvor does not
have to pay any interest on the note over the 3-year period.
P14.13 (LO 3) (Debtor Entries for Continuation of Debt with New Effective Interest)
Crocker plc owes Yaeger Ltd. a 10-year, 10% note in the amount of £330,000 plus £33,000 of accrued
interest. The note is due today, December 31, 2022. Because Crocker is in financial trouble, Yaeger
agrees to forgive the accrued interest, and £30,000 of the principal, and to extend the maturity date to
December 31, 2025. Interest at 10% of revised principal will continue to be due on 12/31 each year.
Given Crocker’s financial difficulties, the market rate for its loans is 12%.
Instructions
a. Prepare the amortization schedule for the years 2022 through 2025.
b. Prepare all the necessary journal entries on the books of Crocker for the years 2022, 2023, and
2024.
P14.14 (LO 1, 3, 4) (Comprehensive Problem: Issuance, Classification,

Reporting) Presented below are three independent situations.
Instructions
a. On January 1, 2022, Langley Co. issued 9% bonds with a face value of $700,000 for $656,992 to
yield 10%. The bonds are dated January 1, 2022, and pay interest annually. What amount is
reported for interest expense in 2022 related to these bonds?
b. Tweedie Building Co. has a number of long-term bonds outstanding at December 31, 2022. These
long-term bonds have the following sinking fund requirements and maturities for the next 6
years.
Sinking Fund Maturities
2023 $300,000 $100,000
2024 100,000 250,000
2025 100,000 100,000
2026 200,000 —
2027 200,000 150,000
2028 200,000 100,000
Indicate how this information should be reported in the financial statements at December 31,
2022.
c. In the long-term debt structure of Beckford Inc., the following three bonds were reported:
mortgage bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in
installments, secured by plant equipment $4,000,000. Determine the total amount, if any, of
debenture bonds outstanding.
Concepts for Analysis

CA14.1 (LO 1, 4) (Bond Theory: Statement of Financial Position Presentations, Interest
Rate, Premium) On January 1, 2023, Nichols Company issued for $1,085,800 its 20-year, 11% bonds
that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. Bond
issue costs were not material in amount. Below are three presentations of the non-current liability
section of the statement of financial position that might be used for these bonds at the issue date.
1. Bonds payable (maturing January 1, 2043) $1,085,800
2. Bonds payable—principal (face value $1,000,000 maturing January 1, 2043) $ 142,050a
Bonds payable—interest (semiannual payment $55,000) 943,750b
Total bond liability $1,085,800
3. Bonds payable—principal (maturing January 1, 2043) $1,000,000
Bonds payable—interest ($55,000 per period for 40 periods) 2,200,000
Total bond liability $3,200,000
aThe present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per
period.
bThe present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.
Instructions
a. Discuss the conceptual merit(s) of each of the date-of-issue statement of financial position
presentations shown above for these bonds.
b. Explain why investors would pay $1,085,800 for bonds that have a maturity value of only
$1,000,000.
c. Assuming that a discount rate is needed to compute the carrying value of the obligations arising
from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of
using for this purpose:
1. The coupon or nominal rate.
2. The effective or yield rate at date of issue.
d. If the obligations arising from these bonds are to be carried at their present value computed by
means of the current market rate of interest, how would the bond valuation at dates subsequent
to the date of issue be affected by an increase or a decrease in the market rate of interest?
CA14.2 (LO 1, 4) (Various Non-Current Liability Conceptual Issues) Schrempf AG

has completed a number of transactions during 2022. In January, the company purchased under
contract a machine at a total price of €1,200,000, payable over 5 years with installments of €240,000
per year. The seller has considered the transaction as an installment sale with the title transferring to
Schrempf at the time of the final payment.
On March 1, 2022, Schrempf issued €10 million of general revenue bonds priced at 99 with a coupon
of 10% payable July 1 and January 1 of each of the next 10 years. The July 1 interest was paid and on
December 30, the company transferred €1,000,000 to the trustee, Flagstad SE, for payment of the
January 1, 2023, interest.
As the accountant for Schrempf, you have prepared the statement of financial position as of December
31, 2022, and have presented it to the president of the company, who asks you the following questions.
1. Why has depreciation been charged on equipment being purchased under contract? Title has not
passed to the company as yet and, therefore, it is not our asset. Why should the company not
show on the left side of the statement of financial position only the amount paid to date instead
of showing the full contract price on the left side and the unpaid portion on the right side? After
all, the seller considers the transaction an installment sale.
2. Bond interest is shown as a current liability. Did we not pay our trustee, Flagstad SE, the full
amount of interest due this period?
Instructions
Outline your answers to these questions by writing a brief paragraph that will justify your treatment.
CA14.3 (LO 1, 3, 4) (Bond Theory: Price, Presentation, and Retirement) On March 1, 2023,
Sealy Sundries sold its 5-year, £1,000 face value, 9% bonds dated March 1, 2023, at an effective annual
interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is
September 1, 2023. Sealy uses the effective-interest method of amortization. The bonds can be called
by Sealy at 101 at any time on or after March 1, 2024.
Instructions
a. 1. How would the selling price of the bond be determined?

2. Specify how all items related to the bonds would be presented in a statement of financial
position prepared immediately after the bond issue was sold.
b. What items related to the bond issue would be included in Sealy’s 2023 income statement, and
how would each be determined?
c. Would the amount of bond discount amortization using the effective-interest method of
amortization be lower in the second or third year of the life of the bond issue? Why?
d. Assuming that the bonds were called in and extinguished on March 1, 2024, how should Sealy
report the retirement of the bonds on the 2024 income statement?
CA14.4 (LO 1, 3, 4) (Bond Theory: Amortization and Gain or Loss Recognition)

Part I: The required method of amortizing a premium or discount on issuance of bonds is the
effective-interest method.
Instructions
How is amortization computed using the effective-interest method, and why and how do amounts
obtained using the effective-interest method provide financial statement readers useful information
about the cost of borrowing?
Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be
accounted for in three ways:
1. Amortized over remaining life of old debt.

2. Amortized over the life of the new debt issue.
3. Recognized in the period of extinguishment.
Instructions
a. Develop supporting arguments for each of the three theoretical methods of accounting for gains
and losses from the early extinguishment of debt.
b. Which of the methods above is generally accepted under IFRS and how should the appropriate
amount of gain or loss be shown in a company’s financial statements?
CA14.5 (LO 4) (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in

building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The
objective is to ensure a steady supply of cans at a stable price and to minimize transportation costs.
However, the company has been experiencing some financial problems and has been reluctant to
borrow any additional cash to fund the project. The company is not concerned with the cash flow
problems of making payments but rather with the impact of adding additional long-term debt to its
statement of financial position.
The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC),
its major supplier, to see if some agreement could be reached. ACC was anxious to work out an
arrangement since it seemed inevitable that Ryan would begin its own can production, and ACC could
not afford to lose the account.
After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on
Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement.
Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC,
paying a unit price which, at normal capacity, would cover labor and material, an operating
management fee, and the debt service requirements on the plant. The expected unit price, if
transportation costs are taken into consideration, is lower than current market. If Ryan did not take
enough production in any one year and if the excess cans could not be sold at a high enough price on
the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on
its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the
purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan.
Instructions
a. What are project financing arrangements using special purpose entities?

b. What are take-or-pay contracts?
c. Should Ryan record the plant as an asset together with the related obligation? If not, should Ryan
record an asset relating to the future commitment?
d. What is meant by off-balance-sheet financing?
CA14.6 (LO 1, 4) (Bond Issue) Donald Lennon is the president, founder, and majority
owner of Edina Medical Group, an emerging medical technology products company. Edina is in dire
need of additional capital to keep operating and to bring several promising products to final
development, testing, and production. Donald, as owner of 51% of the outstanding shares, manages
the company’s operations. He places heavy emphasis on research and development and long-term
growth. The other principal shareholder is Nina Friendly who, as a non-employee investor, owns 40%
of the shares. Nina would like to deemphasize the R&D functions and emphasize the marketing
function to maximize short-run sales and profits from existing products. She believes this strategy
would raise the market price of Edina’s shares.
All of Donald’s personal capital and borrowing power are tied up in his 51% share ownership. He
knows that any offering of additional shares will dilute his controlling interest because he won’t be
able to participate in such an issuance. But Nina has money and would likely buy enough shares to
gain control of Edina. She then would dictate the company’s future direction, even if it meant
replacing Donald as president.
The company already has considerable debt. Raising additional debt will be costly, will adversely affect
Edina’s credit rating, and will increase the company’s reported losses due to the growth in interest
expense. Nina and the other minority shareholders express opposition to the assumption of additional
debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain control and
to preserve the direction of “his” company, Donald is doing everything to avoid a share issuance and is
contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-
interest rate.
Instructions
a. Who are the stakeholders in this situation?

b. What are the ethical issues in this case?
c. What would you do if you were Donald?
Using Your Judgment
Financial Reporting Problem
Marks and Spencer plc (M&S)

The financial statements of M&S (GBR) are presented in Appendix A. The company’s complete annual
report, including the notes to the financial statements, is available online.
Instructions
Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
a. What cash outflow obligations related to the repayment of long-term debt does M&S have over
the next 5 years?
b. M&S indicates that it believes that it has the ability to meet business requirements in the
foreseeable future. Prepare an assessment of its liquidity, solvency, and financial flexibility using
ratio analysis.
Comparative Analysis Case

adidas and Puma
The financial statements of adidas (DEU) and Puma (DEU) are presented in Appendices B and C,
respectively. The complete annual reports, including the notes to the financial statements, are
available online.
Instructions
Use the companies’ financial information to answer the following questions.
a. Compute the debt to assets ratio and the times interest earned for these two companies.
Comment on the quality of these two ratios for both adidas and Puma.
b. What is the difference between the fair value and the historical cost (carrying amount) of each
company’s borrowings at year-end 2018? Why might a difference exist in these two amounts?
c. Do these companies have debt issued in foreign countries? Speculate as to why these companies
may use foreign debt to finance their operations. What risks are involved in this strategy, and how
might they adjust for this risk?
Financial Statement Analysis Cases
Case 1 Commonwealth Edison Co.
The following article about Commonwealth Edison Co. (USA) appeared in the Wall Street Journal.
Bond Markets
Giant Commonwealth Edison Issue Hits Resale Market With $70 Million Left Over
NEW YORK—Commonwealth Edison Co.’s slow-selling new 9¼% bonds were tossed onto the
resale market at a reduced price with about $70 million still available from the $200 million
offered Thursday, dealers said.
The Chicago utility’s bonds, rated double-A by Moody’s and double-A-minus by Standard & Poor’s,
originally had been priced at 99.803, to yield 9.3% in 5 years. They were marked down yesterday
the equivalent of about $5.50 for each $1,000 face amount, to about 99.25, where their yield
jumped to 9.45%.
Instructions
a. How will the development above affect the accounting for Commonwealth Edison’s bond issue?
b. Provide several possible explanations for the markdown and the slow sale of Commonwealth
Edison’s bonds.
Case 2 Eurotec
Consider the following events relating to Eurotec’s long-term debt in a recent year.
1. The company decided on February 1 to refinance €500 million in short-term 7.4% debt to make it
long-term 6%.
2. €780 million of long-term zero-coupon bonds with an effective-interest rate of 10.1% matured
July 1 and were paid.
3. On October 1, the company issued €250 million in 6.3% bonds at 102 and €95 million 11.4%
bonds at 99.
4. The company holds €100 million in perpetual foreign interest payment bonds that were issued in
1989 and presently have a rate of interest of 5.3%. These bonds are called perpetual because they
have no stated due date. Instead, at the end of every 10-year period after the bond’s issuance, the
bondholders and Eurotec have the option of redeeming the bonds. If either party desires to
redeem the bonds, the bonds must be redeemed. If the bonds are not redeemed, a new interest
rate is set, based on the then-prevailing interest rate for 10-year bonds. The company does not
intend to cause redemption of the bonds but will reclassify this debt to current next year since the
bondholders could decide to redeem the bonds.
Instructions
a. Consider event 1. What are some of the reasons the company may have decided to refinance this
short-term debt, besides lowering the interest rate?
b. What do you think are the benefits to the investor in purchasing zero-coupon bonds, such as
those described in event 2? What journal entry would be required to record the payment of these
bonds? If financial statements are prepared each December 31, in which year would the bonds
have been included in current liabilities?
c. Make the journal entry to record the bond issues described in event 3. Note that the bonds were
issued on the same day, yet one was issued at a premium and the other at a discount. What are
some of the reasons that this may have happened?
d. What are the benefits to Eurotec in having perpetual bonds as described in event 4? Suppose that
in the current year, the bonds are not redeemed and the interest rate is adjusted to 6% from 7.5%.
Make all necessary journal entries to record the renewal of the bonds and the change in rate.
Accounting, Analysis, and Principles

The following information is taken from the 2022 annual report of Bugant SA. Bugant’s fiscal year
ends December 31 of each year.
Bugant SA
Statement of Financial Position
December 31, 2022
Assets
Plant and equipment (net of accumulated depreciation of €160) €1,840
Inventory €1,800
Cash 450
Total current assets 2,250
Total assets €4,090
Equity
Share capital €1,500
Retained earnings 1,164
Liabilities
Bonds payable (net of discount) 1,426
Total equity and liabilities €4,090
Note X: Long-Term Debt

On January 1, 2020, Bugant issued bonds with face value of €1,500 and coupon rate equal to 10%.
The bonds were issued to yield 12% and mature on January 1, 2025.
Additional information concerning 2023 follows.
1. Sales were €2,922, all for cash.

2. Purchases were €2,000, all paid in cash.
3. Salaries were €700, all paid in cash.
4. Plant and equipment was originally purchased for €2,000 and is depreciated on a straight-line
basis over a 25-year life with no residual value.
5. Ending inventory was €1,900.
6. Cash dividends of €100 were declared and paid by Bugant.
7. Ignore taxes.
8. The market rate of interest on bonds of similar risk was 16% during all of 2023.
9. Interest on the bonds is paid semiannually each June 30 and December 31.
Accounting
Prepare an income statement for Bugant for the year ending December 31, 2023, and a statement of
financial position at December 31, 2023. Assume semiannual compounding.
Analysis
Use common ratios for analysis of long-term debt to assess Bugant’s long-run solvency. Has Bugant’s
solvency changed much from 2022 to 2023? Bugant’s net income in 2022 was €550 and interest
expense was €169.
Principles
The FASB and the IASB allowed companies the option of recognizing in their financial statements the
fair values of their long-term debt. That is, companies have the option to change the statement of
financial position value of their long-term debt to the debt’s fair value and report the change in
statement of financial position value as a gain or loss in income. In terms of the qualitative
characteristics of accounting information (Chapter 2), briefly describe the potential trade-off(s)
involved in reporting long-term debt at its fair value.
Bridge to the Profession

Authoritative Literature References
[1] International Financial Reporting Standard 9, Financial Instruments (London, U.K.: IFRS
Foundation, 2013), par. 4.2.1.
Foundation, 2013), par. B5.1.2A.
Foundation, 2013), par. 3.3.
Foundation, 2013), par. B3.3.6.
Foundation, November 2013), paras. 5.7.7–5.7.8.
[9] International Financial Reporting Standard 10, Consolidated Financial Statements (London, U.K.:
International Accounting Standards Committee Foundation, May 2011), paras. IN8–IN9.
[10] International Accounting Standard 1, Presentation of Financial Statements (London, U.K.:
International Accounting Standards Committee Foundation, 2003), paras. 69–76.
Research Case
Wie Company has been operating for just 2 years, producing specialty golf equipment for women
golfers. To date, the company has been able to finance its successful operations with investments from
its principal owner, Michelle Wie, and with cash flows from operations. However, current expansion
plans will require some borrowing to expand the company’s production line.
As part of the expansion plan, Wie is contemplating a borrowing on a note payable or issuance of
bonds. In the past, the company has had little need for external borrowing so the management team
has a number of questions concerning the accounting for these new non-current liabilities. They have
asked you to conduct some research on this topic.
Instructions
Access the IFRS authoritative literature at the IFRS website (you may register for free IFRS access at
this site). When you have accessed the documents, you can use the search tool in your Internet
browser to respond to the following questions. (Provide paragraph citations.)
a. With respect to a decision of issuing notes or bonds, management is aware of certain costs (e.g.,
printing, marketing, and selling) associated with a bond issue. How will these costs affect Wie’s
reported earnings in the year of issue and while the bonds are outstanding?
b. If all goes well with the plant expansion, the financial performance of Wie Company could
dramatically improve. As a result, Wie’s market rate of interest (which is currently around 12%)
could decline. This raises the possibility of retiring or exchanging the debt, in order to get a lower
borrowing rate. How would such a debt extinguishment be accounted for?
Global Accounting Insights
Compare the accounting for liabilities under IFRS and U.S. GAAP.
U.S. GAAP and IFRS have similar definitions for liabilities. In addition, the accounting for current
liabilities is essentially the same under both IFRS and U.S. GAAP. However, there are substantial
differences in terminology related to non-current liabilities, as well as some differences in the
accounting for various types of long-term debt transactions.
Relevant Facts
Similarities
As indicated above, U.S. GAAP and IFRS have similar liability definitions. Both also classify
liabilities as current and non-current.
Much of the accounting for bonds and long-term notes is the same under U.S. GAAP and IFRS.
Under U.S. GAAP and IFRS, bond issue costs are netted against the carrying amount of the bonds.
Both U.S. GAAP and IFRS require the best estimate of a probable loss. In U.S. GAAP, the
minimum amount in a range is used. Under IFRS, if a range of estimates is predicted and no
amount in the range is more likely than any other amount in the range, the midpoint of the range
is used to measure the liability.
Both U.S. GAAP and IFRS prohibit the recognition of liabilities for future losses.
Differences
Under U.S. GAAP, companies must classify a refinancing as current only if it is completed before
the financial statements are issued. IFRS requires that the current portion of long-term debt be
classified as current unless an agreement to refinance on a long-term basis is completed before
the reporting date.
U.S. GAAP uses the term contingency in a different way than IFRS. A contingency under U.S.
GAAP may be reported as a liability under certain situations. IFRS does not permit a contingency
to be recorded as a liability.
U.S. GAAP uses the term estimated liabilities to discuss various liability items that have some
uncertainty related to timing or amount. IFRS generally uses the term provisions.
U.S. GAAP and IFRS are similar in the treatment of environmental liabilities. However, the
recognition criteria for environmental liabilities are more stringent under U.S. GAAP:
Environmental liabilities are not recognized unless there is a present legal obligation and the fair
value of the obligation can be reasonably estimated.
U.S. GAAP uses the term troubled debt restructurings and develops recognition rules related to
this category. IFRS generally assumes that all restructurings should be considered
extinguishments of debt.
Under U.S. 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 method.
Under U.S. GAAP, companies record discounts and premiums in separate accounts (see the About
the Numbers section). Under IFRS, companies do not use premium or discount accounts but
instead show the bond at its net amount.
Under U.S. GAAP, losses on onerous contracts are generally not recognized unless addressed by
industry- or transaction-specific requirements. IFRS requires a liability and related expense or
cost be recognized when a contract is onerous.
About the Numbers

Under IFRS, premiums and discounts are netted against the face value of the bonds for recording
purposes. Under U.S. GAAP, discounts and premiums are recorded in separate accounts. To illustrate,
consider the €100,000 of bonds dated January 1, 2022 (8 percent coupon, paid semiannually), issued
by Evermaster to yield 6 percent on January 1, 2022. Recall from the discussion earlier in this chapter
that the price of these bonds was €108,530. Using U.S. GAAP procedures, Evermaster makes the
following entry to record issuance of the bonds.
January 1, 2022
Cash 108,530
Bonds payable 100,000
Premium on Bonds Payable 8,530
(€108,530 − €100,000)
As indicated, the bond premium is recorded in a separate account (the account, “Discount on Bonds
Payable,” has a debit balance and is used for bonds issued at a discount). Evermaster makes the
following entry on the first interest payment date.
January 1, 2022
Premium on Bonds Payable (€4,000 − €3,256) 744
Cash (€100,000 × .08 × 6/ )
12 4,000
Following this entry, the net carrying value of the bonds is as follows.
Bonds payable €100,000
Premium on bonds payable (€8,530 − €744) 7,786
Carrying value of bonds payable €107,786
Thus, with a separate account for the premium, entries to record amortization are made to the
premium account, which reduces the carrying value of the bonds to face value over the life of the
bonds.
GAAP Self-Test Questions

1. Under U.S. GAAP, bond issuance costs, including the printing costs and legal fees associated with
the issuance, should be:
a. expensed in the period when the debt is issued.

b. recorded as a reduction in the carrying value of bonds payable.
c. accumulated in a deferred charge account and amortized over the life of the bonds.
d. reported as an expense in the period the bonds mature or are redeemed.
2. Which of the following is stated correctly?
a. Current liabilities follow non-current liabilities on the statement of financial position under U.S.
GAAP but non-current liabilities follow current liabilities under IFRS.
b. IFRS does not treat debt modifications as extinguishments of debt.
c. Bond issuance costs are recorded as a reduction of the carrying value of the debt under U.S. GAAP
but are recorded as an asset and amortized to expense over the term of the debt under IFRS.
d. Under U.S. GAAP, bonds payable is recorded at the face amount and any premium or discount is
recorded in a separate account. Under IFRS, bonds payable is recorded at the carrying value so no
separate premium or discount accounts are used.
3. All of the following are differences between IFRS and U.S. GAAP in accounting for liabilities
except:
a. When a bond is issued at a discount, U.S. GAAP records the discount in a separate contra liability
account. IFRS records the bond net of the discount.
b. Under IFRS and U.S. GAAP, bond issuance costs reduce the carrying value of the debt.
c. U.S. GAAP, but not IFRS, uses the term “troubled-debt restructurings.”
d. U.S. GAAP, but not IFRS, uses the term “provisions” for contingent liabilities that are accrued.
4. All of the following are similarities in the accounting for liabilities under IFRS and U.S. GAAP
except:
a. Bond issue costs are netted against the carrying amount of the bonds.
b. Both U.S. GAAP and IFRS have similar liability definitions.
c. Recognition of liabilities for future losses is allowed under U.S. GAAP and IFRS.
d. Both U.S. GAAP and IFRS require the best estimate for a probable loss, with U.S. GAAP selecting
the minimum amount in the range.
5. On January 1, Martinez Inc. issued $3,000,000, 11% bonds for $3,195,000. The market rate of
interest for these bonds is 10%. Interest is payable annually on December 31. Martinez uses the
effective-interest method of amortizing bond premium. At the end of the first year, Martinez should
report bonds payable of:
a. $3,185,130.
b. $3,184,500.
c. $3,173,550.
d. $3,165,000.
GAAP Concepts and Application

GAAP14.1 Briefly describe some of the similarities and differences between U.S. GAAP and IFRS with
respect to the accounting for liabilities.
GAAP14.2 Diaz Company issued $100,000 face value, 9% coupon bonds on January 1, 2021, for
$92,608 to yield 11%. The bonds mature in 5 years and pay interest annually on December 31. Prepare
the entries under U.S. GAAP for Diaz for (a) date of issue, (b) first interest payment date, and (c)
January 1, 2023, when Diaz calls and extinguishes the bonds at 101.
Answers to GAAP Self-Test Questions

1. b 2. d 3. d 4.c 5. b
Notes
1 It is generally the case that the stated rate of interest on bonds is set in rather precise decimals (such
as 10.875 percent). Companies usually attempt to align the stated rate as closely as possible with
the market or effective rate at the time of issue.
2 The carrying value is the face amount minus any unamortized discount or plus any unamortized
premium. The term carrying value is synonymous with book value.
3 The issuance of bonds involves engraving and printing costs, legal and accounting fees,
commissions, promotion costs, and other similar charges. These costs should be recorded as a
reduction of the issue amount of the bond payable and then amortized into expense over the life of
the bond, through an adjustment to the effective-interest rate (see Underlying Concepts). [2]
For example, if the face value of the bond is €100,000 and issue costs are €1,000, then the bond
payable (net of the bond issue costs) is recorded at €99,000. Thus, the effective-interest rate will be
higher, based on the reduced carrying value.
Underlying Concepts
Because bond issue costs do not meet the definition of an asset, some argue they should be
expensed at issuance.
4 Because companies pay interest semiannually, the interest rate used is 5% (.10 × 6/12). The number
of periods is 10 (5 years × 2).
5 The issuer may call some bonds at a stated price after a certain date. This call feature gives the
issuing company the opportunity to reduce its bonded indebtedness or take advantage of lower
interest rates. Whether bonds are callable or not, a company must amortize any premium or
discount over the bond’s life to maturity because early redemption (call of the bond) is not a
certainty.
6 Determination of the price of a bond between interest payment dates generally requires use of a
financial calculator because the time value of money tables shown in this text do not have factors
for all compounding periods. For homework purposes, the price of a bond sold between interest
dates will be provided.
7 Although we use the term “note” throughout this discussion, the basic principles and methodology
apply equally to other long-term debt instruments.
8
$327 = $1,000 (P V F 8,i )
$327
P V F 8,i = = .327
$1,000
.327 = 15% (in Table 6 .2, locate .32690).
9 Points, in mortgage financing, are analogous to the original issue discount of bonds.
10 One of the many changes that occurred in the aftermath of the financial crisis of 2008–2009 was
recognizing that LIBOR was not a reliable measure of interest rates between banks. As a result, the
G20 requested that the Financial Stability Board (FSB) examine alternative methods to determine
one or more reliable benchmark rates. This process is ongoing but will either result in an
alternative approach to measure LIBOR, or the replacement of LIBOR with a more market-based
interest rate.
11 Some companies have attempted to extinguish debt through an in-substance defeasance. In-
substance defeasance is an arrangement whereby a company provides for the future repayment
of a long-term debt issue by placing purchased securities in an irrevocable trust. The company
pledges the principal and interest of the securities in the trust to pay off the principal and interest
of its own debt securities as they mature. However, it is not legally released from its primary
obligation for the debt that is still outstanding. In some cases, debtholders are not even aware of
the transaction and continue to look to the company for repayment. This practice is not considered
an extinguishment of debt, and therefore the company does not record a gain or loss. [4]
12 The issuer of callable bonds must generally exercise the call on an interest date. Therefore, the
amortization of any discount or premium will be up to date, and there will be no accrued interest.
However, early extinguishments through purchases of bonds in the open market are more likely to
be on other than an interest date. If the purchase is not made on an interest date, the discount or
premium must be amortized, and the interest payable must be accrued from the last interest date to
the date of purchase.
13 Likewise, the creditor must determine the excess of the receivable over the fair value of those same
assets or equity interests transferred. The creditor normally charges the excess (loss) against
Allowance for Doubtful Accounts. Creditor accounting for these transactions is addressed in
Chapter 7.
14 An exception to the general rule occurs when the modification of terms is not substantial. A
substantial modification exists when (1) the discounted cash flows under the terms of the new
debt (using the historical effective-interest rate) differ by at least 10 percent of the carrying value of
the original debt, or (2) there is a substantial and fundamental change in the terms and conditions
of the new borrowing compared to the original borrowing. If a modification is not substantial, the
difference (gain) is deferred and amortized over the remaining life of the debt at the (historical)
effective-interest rate. [5] In the case of a non-substantial modification, in essence, the new loan is
a continuation of the old loan. Therefore, the debtor should record interest at the historical
effective-interest rate.
15 Throughout the text, we use the label “statement of financial position” rather than “balance sheet”
in referring to the financial statement that reports assets, liabilities, and equity. We use off-
balance-sheet in the present context because of its common usage in financial markets.
16 The IASB has issued consolidation guidance that looks beyond equity ownership as the primary
criterion for determining whether an off-balance-sheet entity (and its assets and liabilities) should
be on-balance-sheet (i.e., consolidated). Specifically, an investor controls an investee when it is
exposed, or has rights, to variable returns from its involvement with the investee and has the ability
to affect those returns through its power over the investee. Thus, the principle of control sets out
the following three elements of control: (1) power over the investee; (2) exposure, or rights, to
variable returns from involvement with the investee; and (3) the ability to use power over the
investee to affect the amount of the investor’s returns. In general, the control principle is applied in
circumstances when voting rights are not the dominant factor in deciding who controls the
investee, such as when any voting rights relate to administrative tasks only and the relevant
activities are directed by means of contractual arrangements. [9] The details of consolidation
accounting procedures are beyond the scope of this text and are usually addressed in an advanced
accounting course.
17 It is unlikely that the IASB will be able to stop all types of off-balance-sheet transactions. Financial
engineering is the Holy Grail of securities markets. Developing new financial instruments and
arrangements to sell and market to customers is not only profitable but also adds to the prestige of
the investment firms that create them. Thus, new financial products will continue to appear that
will test the ability of the IASB to develop appropriate accounting standards for them.

1.kieso 2020-1118-1183

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1.kieso 2020-1118-1183

Uploaded by

Copyright:

Available Formats

CHAPTER 14

Review and Practice

Non-current liabilities (sometimes referred to as long-term debt) consist of an expected outflow of

What Do the Numbers Mean?

Valuation and Accounting for Bonds Payable

Bonds Issued at Par

ILLUSTRATION 14.1 Time Diagram for Bonds Issued at Par

ILLUSTRATION 14.2 Present Value Computation of Bond Selling at Par

ILLUSTRATION 14.3 Time Diagram for Bonds Issued at a Discount

ILLUSTRATION 14.4 Present Value Computation of Bond Selling at a Discount

What Do the Numbers Mean?

Illustration 14.5 depicts graphically the computation of the amortization.

ILLUSTRATION 14.5 Bond Discount and Premium Amortization Computation

Bonds Issued at a Discount

Maturity value of bonds payable €100,000

ILLUSTRATION 14.6 Computation of Discount on Bonds Payable

ILLUSTRATION 14.7 Bond Discount Amortization Schedule

Bonds Issued at a Premium

ILLUSTRATION 14.8 Computation of Premium on Bonds Payable

ILLUSTRATION 14.9 Bond Premium Amortization Schedule

Interest accrual (€4,000 × 2/6) €1,333.33

ILLUSTRATION 14.10 Computation of Interest Expense

ILLUSTRATION 14.11 Computation of Premium Amortization

Bonds Issued Between Interest Dates

Bonds Issued at Par

Bonds Issued at Discount or Premium

ILLUSTRATION 14.12 Partial Period Interest Amortization

Cash interest paid on July 1, 2022 (€100,000 × .08 × 6/12) €4,000

ILLUSTRATION 14.13 Partial Period Interest Amortization

Long-Term Notes Payable

Notes Issued at Face Value

Notes Not Issued at Face Value

ILLUSTRATION 14.14 Time Diagram for Zero-Interest Note

ILLUSTRATION 14.15 Schedule of Note Discount Amortization

ILLUSTRATION 14.16 Schedule of Note Discount Amortization

Special Notes Payable Situations

1. No interest rate is stated, or

Health Spa Services (Buyer) Scenic Development AS (Seller)

ILLUSTRATION 14.17 Entries for Non-Cash Note Transaction

Choice of Interest Rate

ILLUSTRATION 14.18 Time Diagram for Interest-Bearing Note

ILLUSTRATION 14.19 Computation of Imputed Fair Value and Note Discount

ILLUSTRATION 14.20 Schedule of Discount Amortization Using Imputed Interest Rate

Mortgage Notes Payable

Extinguishment of Non-Current Liabilities

How do companies record the payment of non-current liabilities—often referred to as

1. Extinguishment with cash before maturity.

Extinguishment with Cash Before Maturity

Schedule of Bond Discount Amortization

ILLUSTRATION 14.21 Bond Premium Amortization Schedule, Bond Extinguishment

ILLUSTRATION 14.22 Computation of Loss on Redemption of Bonds

Extinguishment by Exchanging Assets or Securities

Granting of Equity Interest

Extinguishment with Modification of Terms

1. Reduction of the stated interest rate.

Reducing the principal obligation from ¥10,500,000 to ¥9,000,000;

Present value of restructured cash flows:

ILLUSTRATION 14.23 Fair Value of Restructured Note

ILLUSTRATION 14.24 Schedule of Interest and Amortization after Debt Modification

Presentation and Analysis

Fair Value Option

Fair Value Measurement

Fair Value Controversy