Accounting for Equities and Liabilities.

BACT 212

ACCOUNTING FOR LONG-TERM LIABILITIES

Introduction
Non-current liabilities are obligations expected to be settled more than one year after the balance
sheet date or the business’s normal operating cycle, whichever is longer. Borrowing comprises the
major portion of non-current liabilities.
Initial Measurement
Non-current financial liabilities should initially be recorded at fair value minus debt issue costs.
Examples of debt issue costs include fees charged by investment banks and regulatory agencies,
legal and accounting fees, and outlays for promotion. Debt instruments exchanged for assets are
recognized at fair value. If the liability is non-interest bearing or the stated rate of interest is
different from the market rate of interest, the fair value of the debt will differ from the face
(maturity) value. This includes bonds issued at a premium or discount. If the note is issued for
consideration other than cash, the fair value must be estimated employing the fair value hierarchy.
In the absence of similar market transactions, discounted cash flow analysis is normally used to
determine the liability to be recognized

Scenario 1 Scenario 2 Scenario 3

Face amount of note issued Sh.150,000 Sh.150,000 Sh.150,000
Date issued Jan 1, 2021 Jan 1, 2021 Jan 1,2021
Due date Jan 1, 2023 Jan 1, 2023 Jan 1, 2023
Interest rate in the note 4% 0% 4% (payable annually
Market rate of interest 4% unknown 6%
Consideration received Cash Equipment Land
Value of similar transaction Not applicable Sh.140,000 Not applicable
Fair value determination Cash received Level 2 input Discounted cash flow
analysis
Journal entry on issuance Dr:cash 150,000 Dr:Equipment Dr: Land 144,500
140,000

Cr: Note payable Cr: Note payable Cr: Note payable

150,000 140,000 144,500

Common non-current liabilities

1. Bonds
Governments and publicly traded companies issue (sell) bonds directly to investors to raise large
amounts of long-term funds. Bonds obligate the issuing corporation to repay a stated amount
(principal, par value, face amount, or maturity value) at a specified maturity date. Maturities for
bonds typically range from 10 to 40 years. The company also agrees to pay interest to bondholders
between the issue date and maturity. The periodic interest is a stated percentage of face amount (
referred to as the stated rate, coupon rate, or nominal rate). Generally, interest is paid semi-annually
on designated interest dates beginning six months after the day the bonds are dated. A bond
indenture is the contract that outlines the terms of the bond, including the maturity date, rate of
interest, interest payment dates, security pledged, and financial covenants. Reasons for issuing
bonds (instead of using a bank loan, for example) include reducing the cost of borrowing and
accessing large amounts of capital.
Bond terminologies
1. Face value-Face value is the designated value per unit of a bond when the bond is issued
by the bond issuer. The principal amount of a bond or note due at maturity
2. Market Value-The market value of a bond is the value at which the bond is currently
being bought and sold in the market.

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3. Yield to Maturity (YTM)-Yield to maturity is the effective returns that an investor gets
by investing in a bond and then holding it till maturity.
4. Coupon-A coupon payment is the amount of annual interest that will be paid to the
bondholder on an annual basis.
Valuation and accounting for bonds
Investors value a bond at the present value of its expected future cash flows, which consist of
1. interest
2. principal.
The interest rate is used to compute the present value of the cash flows. The interest rate written
in the terms of the bond indenture is known as the stated, coupon, or nominal 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). 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.
▪ 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 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. There is an inverse relationship between the market
interest rate and the price of the bond.
Computing the present value of a bond
Illustration 1
Assume that ServiceMaster issues sh.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.
Determine the price of the bond

Interest rates and bond price

The coupon or stated rate of interest on a bond is the interest rate specified in the bond indenture
(contract). The coupon rate is expressed as a percentage of the bond’s face value and governs the
amount of interest paid by the borrower at each payment date. For example, a sh.1,000, 5-year,
6%, semi-annual bond pays sh.30 (sh.1,000 × 6%*1/2) interest to the investor every six months.
The market rate of interest or yield is the rate of return (on a bond) actually earned by the investor.
The market rate of interest factors in the interest payments received over the life of the bond, and
any discount received or premium paid at the purchase date.
It is calculated as follows:

𝐹𝑉 − 𝑃𝑉
𝑐+
Market rate/YTM = 𝑡
𝐹𝑉 + 𝑃𝑉
2

Where C interest/Coupon payment

FV Face value of the bond
PV Present value/price of the bond

Illustration 2
Determine the market rate of interest for a sh.1,000, 5-year, 6%, semi-annual bond purchased for
sh.990
Determine the effective interest rate for a sh.1,000, 5-year, 6%, semi-annual bond sold for sh.990
with sh5 directly attributable transaction costs

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For the borrower, the effective interest rate is the rate of interest paid (on a bond). The effective
interest rate factors in the interest payments made over the life of the bond, discounts given or
premiums received at the issuance date, and the borrower’s transaction costs that are directly
attributed to issuing the bonds (e.g., investment bank and legal fees).

When the coupon rate is less than the market rate, bonds will sell at a discount. Conversely, when
the coupon rate exceeds the market rate, bonds will sell at a premium. Thus, there is an inverse
relationship between bond price and the market rate of interest

Illustration 3
A sh.100,000, 5-year, 12% bond that pays interest semi-annually dated January 1, 2018, is offered
for sale on January 1, 2018. Determine the market rate (yield to maturity)

Scenario 1 Scenario 2 Scenario 3

Sh.100,000 in bonds Sh.100,000 bonds are Sh.100,000 in bonds
are sold for Sh.99,000 sold for sh.100,000 are sold for
sh.101,000
Maturity value Sh.100,000 Sh.100,000 Sh. 100,000
Interest payments 6,000 6,000 6,000
100,000*12*1/2
Number of payments 10 10 10
(5*2)
Price received for the Sh.99,000 Sh.100,000 Sh.101,000
bond

Determining the selling price of a bond

1. Bonds issued at par on interest rate date -When a company issues bonds on an interest
payment date at par (face value), it accrues no interest. No premium or discount exists. The
company simply records the cash proceeds and the face value of the bonds.

Illustration 4
A sh.100,000, five-year, 6% bond that pays interest semi-annually dated January 1, 2018, is offered
for sale on January 1, 2018. The bond is sold to yield a 7% return to the investors.
Required: Determine the selling price of the bonds and make the necessary journal entries.

2. Bonds issued at Discount or premium-A bond maybe sold for more than face amount (at a
premium) or less than face amount (at a discount), depending on how the stated interest rate
compares with the prevailing market or effective rate of interest (for securities of similar risk
and maturity).

Illustration 5
On January 1, 2021, Masterwear Industries issued sh.700,000 of 12% bonds.
▪ Interest of sh.42,000 is payable semi-annually on June 30 and December 31.
▪ The bonds mature in three years.
▪ The market yield for bonds of similar risk and maturity is 14%.
▪ United group, the sole investor in the bonds, planned to hold the bonds to their maturity.
Required: Determine the price of the bonds and make the necessary journal entries

Illustration 6
Buchanan Company issues the sh.800,000 of bonds on January 1, 2020, at 97 (meaning 97% of
par). Provide the necessary journal entries.

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Illustration 7
A sh.100,000, five-year, 6% bond that pays interest semi-annually dated January 1, 2018, is offered
for sale on January 1, 2018. The bond is sold to yield a 7% return to the investors.
Required: Determine the selling price of the bond

Subsequent measurement
a. Determining interest-effective interest rate
After initial recognition, all financial liabilities are measured and reported at amortized cost, which
is the amount initially recognized for the debt adjusted by subsequent amortization of the net
premium or discount. There are two steps used to determine the amortized cost of a financial
liability:
1. Establishing the effective interest rate- the effective interest method must be used to
determine amortized cost. Applying this method requires the effective interest rate, which is
the rate of interest paid by the borrower that factors in premiums or discounts at issuance and
transaction costs.

2. Amortizing the premium or discount using the effective interest method.

i. Interest payment coincides with fiscal year-end- this involves computing interest expense
and determining the amortized cost of bonds to be reported at each balance sheet
Illustration 8
Bay ltd sells Sh.1,000,000 of three-year bonds on January 1, 2018, for Sh.981,000.
• The coupon rate on the bonds is 6% payable on July 1 and January 1.
• Transaction costs directly attributable to issuing the bonds total Sh.15,000.
• Bay Ltd fiscal year-end is December 31
Required:
a. Compute the effective interest rate and amortization schedule for Bay ltd.
b. Prepare the necessary journal entries
Illustration 9
Bay Ltd sells sh.1,000,000 of three-year bonds on January 1, 2018, for sh.1,025,000.
o The coupon rate on the bonds is 6% payable on July 1 and January 1.
o Transaction costs directly attributable to issuing the bonds total $15,000.
o Port ltd fiscal year-end is December 31.
Required: Make journal entries for the above transactions

When interest expense do not coincide with fiscal year end

If the interest payment and fiscal year-end dates differ, amortization of the discount or premium
is prorated.

Illustration 10
Bay Ltd sells sh.1,000,000 of three-year bonds on January 1, 2018, for sh.1,025,000.
o The coupon rate on the bonds is 6% payable on July 1 and January 1.
o Transaction costs directly attributable to issuing the bonds total $15,000.
o Bay Ltd’s fiscal year-end is Octomber31.
Required: Make journal entries for the above transaction

3. Amortization using straight line method

In some circumstances, a company is allowed to determine interest indirectly by allocating a
discount or a premium equally to each period over the term to maturity—if doing so produces
results that are not materially different from the usual (and preferable) interest method. The
decision should be guided by whether the straight-line method would tend to mislead investors
and creditors in the particular circumstance.

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Illustration 11
Longhorn Educational Services Ltd. sells sh.1,000,000 of three-year bonds on January 1, 2018, for
sh.973,357. The coupon rate on the bonds is 6% per year, payable on July 1 and January 1; the
bonds yield 7% per year, or 3.5% per period. Longhorn Educational Services’ year-end is
December 31.
Required: Determine the interest expense per period

Derecognition
Derecognition of financial liability involves removing the liability from an entity’s balance sheet.
Firms can derecognize liabilities when they extinguish the obligations or when the underlying
contract is discharged, cancelled, or expires. Extinguishment occurs when the entity pays off the
debt or when it legally no longer has primary responsibility for the liability.
a) Derecognition at maturity-The common way to extinguish obligations is to settle them when
due.
Illustration 12
Show the journal entries to record he recognition of Longhorn Educational Services bond on
maturity

b) Derecognition before maturity-Companies sometimes pay off their obligations prior to

maturity. Derecognition of a financial liability should follow these steps:
1. The company updates its records to account for interim interest expense, including the
amortization of discounts or premiums up to the derecognition date.
2. The entity records the outflow of assets expended to extinguish the obligation.
3. The entity records a gain or loss on debt retirement equal to the difference between the
amount paid and the book value of the liability derecognized.
Illustration 13
On October 1, 2019, Bay Ltd. repurchases the bonds issued in illustration 8. Bay repurchases the
bonds on the open market for total consideration of sh.980,000 cash

If the entity retires only a portion of a liability, the obligation is derecognized on a pro rata basis.
For example, if a company retires 40% of a bond, it would derecognize 40% of the book value,
including 40% of the unamortized premium or discount.

Illustration 14
Bay ILtd. repurchases the bonds issued in illustration 8. Bay calls the bonds and pays each holder
the face amount of the bonds, plus accrued interest (sh.15,000), together with a 2% call premium
(sh.20,000). The total consideration paid is sh.1,035,000

Comprehensive review exercise

Creative Conundrums Ltd. (CCL) raised sh.9,500,000 before expenses by selling sh.10,000,000 of
five-year, 5% bonds dated January 1, 2018. CCL used part of the proceeds to pay its investment
bank’s fee of sh.200,000 and related legal and accounting fees of sh.300,000. Interest is payable on
June 30 and December 31 each year. CCL can call the bonds on January 1, 2020, at 102 (“102”
means 102% of the face value, so for each Sh.1,000 bond outstanding CCL will pay the holder
$1,020 plus accrued interest). The company exercises this privilege, redeeming 60% of the bonds
on the call date. The company’s year-end is December 31.
Required
Prepare journal entries to record the following:
a) The issuance of the bonds on January 1, 2018.
b) Payment of interest and related amortization on June 30, 2018.
c) Payment of interest and related amortization on December 31, 2019.

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d) Repurchase of the bonds on January 1, 2020.

e) Retirement of the remaining bonds on December 31, 2022, assuming that the final interest
payment has already been recorded in the company’s books.

2. Long-term notes payable

Long-term notes are similar 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. 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. 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 shown earlier in this chapter

Presentation and Disclosure

Companies that have large amounts and numerous issues of long-term debt frequently report only
one amount in the balance sheet, 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 stock, or retire it from a bond retirement fund, it
should continue to report the debt as noncurrent. However, the company should disclose the
method it will use in its liquidation. 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 balance sheet. The fair value of the long-term
debt should also be disclosed if it is practical to estimate fair value. 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

Assignment 1
Three independent situations follow:
1. First Corp. (FC) issued sh.7,000,000 in stripped (zero-coupon) bonds that mature in eight
years. The market rate of interest for bonds of a similar nature is 4.8% compounded
monthly. Four and a half years after issue, when the market rate was 3.6%, FC repurchased
sh.3,000,000 of the bonds on the open market. FC accrues interest monthly. Bonds are
carried at amortized cost.
2. The Crazy Car Dealer sold sh. 4,000,000 of five-year bonds that pay the then-current
market rate of interest of 3% annually on December 31. The bonds are dated January 1,
2019, but were not issued until March 1, 2019. Crazy’s year-end is December 31. Crazy
has adopted a policy of crediting interest expense for the interest accrued up to the date
of sale.
3. On January 1, 2019, Creative Ltd. (CL) sold Sh.3,000,000 of three-year, 5% bonds priced
to yield 5.5%. Interest is payable on June 30 and December 31 each year.
Required:
a. Prepare journal entries to record:
i. The sale and retirement of the bonds in Scenario 1.
ii. The sale of the bonds in Scenario 2 and payment of interest on December 31, 2019.
iii. The sale of the bonds in Scenario 3.
b. Prepare a schedule of interest expense and bond amortization during the life of the bondin
Scenario 3.
Assignment Two
Three independent situations follow:

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1. IA Ltd. (IAL) issued sh.5,000,000 in stripped (zero-coupon) bonds that mature in10 years.
The market rate of interest for bonds of a similar nature is 3.6% compounded monthly.
Five and a half years after issue, when the market rate was 4.8%, IAL repurchased
Sh.2,000,000 of the bonds on the open market. IAL accrues interest monthly. Bonds are
carried at amortized cost.
2. CA sold Sh.2,000,000 of five-year bonds that pay the then-current market rate of interest
of 6% annually on December 31. The bonds are dated January 1, 2018, but were not issued
until February 1, 2018. CA’s year-end is December 31. CA has adopted a policy of crediting
interest expense for the interest accrued up to the date of sale.
3. On January 1, 2020, AMPC sold sh.3,000,000 of three-year, 5% bonds priced to yield 4.5%.
Interest is payable on June 30 and December 31 each year.
Required:
a. Prepare journal entries to record:
i. The sale and retirement of the bonds in Scenario 1.
ii. The sale of the bonds in Scenario 2 and payment of interest on December 31, 2018.
iii. The sale of the bonds in Scenario 3.
b. Prepare a schedule of interest expense and bond amortization during the life of the bond
in Scenario 3.

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