Financial Reporting

Day 13 and 14
Long-Term Liabilities

Objectives

1. Extinguishment of Debt
2. Interest rate on note is not stated or unrealistic
3. Fair value option for financial instruments
4. Ratios
5. Amortization schedules for debt
6. Troubled-debt restructuring

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Types of Bonds
Illustration:
Type of Bond Characteristics
Secured Bonds 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 stocks and bonds of other
corporations.
Unsecured 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.
Term Bonds that mature on a single date
Serial Bonds that mature in installments. Serially maturing bonds are frequently used by
school or sanitary districts, municipalities, or other local taxing bodies that receive
money through a special levy.
Callable Bonds that give the issuer the right to call and redeem the bonds prior to maturity.
Convertible Bonds that are convertible into other securities (usually common stock) of the
corporation for a specified time after issuance.
Deep-Discount (zero- Bonds that are sold at a discount that provide the investor’s total interest payoff at
interest debenture) maturity.
Revenue Bonds on which interest is paid from specified revenue sources; most frequently issued
by airports, school districts, counties, toll-road authorities, and governmental bodies.
Income Bonds that pay no interest unless the issuing company is profitable.

LO 1
A. Bond Definitions - interest rates
i) Stated, coupon, or nominal rate =

ii) Effective, yield, or market rate=

Cash interest =

Interest expense =

B. Bond Prices - an example

Example: Suppose you issue a 3-year, 12%, $1,000 bond that pays semiannual
interest. How much will the bond sell for if the bond yield is 16%? 8%?

Step ONE: What are the bond's cash flows?

Step TWO: Bond Prices
Priced to Yield 8% PV of Bond Cash Flows
Cash Flow PV Present Value

1. Face 1,000 0.7903

1. Interest 60 5.24

Bond Price is

Priced to Yield 16% PV of Bond Cash Flows

Cash Flow PV Present Value

1. Face 1,000 0.63

1. Interest 60 4.62

Bond Price is
C. Bond journal entries at issuance
Premium Discount
Cash Cash
Bond Payable (face) Discount on bond
Premium on bond Bond payable (face)

Carrying Value = Face + Premium Carrying Value = Face - Discount

Balance Sheet Presentation at Issuance

Premium Discount
Long-term Liabilities Long-term Liabilities

Bond Payable (face) Bond Payable (face)

+ Premium on bond __________ less: Discount on bond _______
Carrying value of bond Carrying value of bond
D. Bond amortization tables - 8% bond yield
EFFECTIVE INTEREST METHOD (Method One)
Premium Amortization
(1) (2) (3) (4)
Payment Interest Carrying
Number Expense Cash Amortization Value
$1,105.00
1 60
2 60
3 60
4 60
5 60
6 60 1,000.00

Reported on the Reported on the

Income Statement Balance Sheet

Interest expense = Previous line’s carrying value ×market rate of interest

Cash interest = Face value × stated rate of interest
Bond Intuition

Market vs. Stated Issued Interest vs. Cash Carrying

Rate Rate at Expense Interest Value
Paid overtime

MR > SR

MR = SR

MR < SR
 STRAIGHT-LINE METHOD (Method Two)
(1) (2) (3) (4)
PaymentInterest Carrying
NumberExpense Cash Amortization Value
$1,105.00
1 42.50 60 17.5 1,087.50
2 42.50 60 17.5 1,070.00
3 42.50 60 17.5 1,052.50
4 42.50 60 17.5 1,035.00
5 42.50 60 17.5 1,017.50
6 42.50 60 17.5 1,000.00
 EFFECTIVE INTEREST METHOD
Discount Amortization
(1) (2) (3) (4)
PaymentInterest Carrying
NumberExpense Cash Amortization Value
$907.54
1 72.60 60 12.60 920.14

2 73.61 60 13.61 933.75

3 74.70 60 14.70 948.46

4 75.88 60 15.88 964.33

5 77.15 60 17.15 981.48

6 78.52 60 18.52 1,000.00

Bonds Issued Between Interest Dates
FACTS On March 1, 2025, GreenTea Corporation issues 10-year bonds at par, dated
January 1, 2025, with a par value of $800,000. These bonds have an annual interest
rate of 6%, payable semiannually on January 1 and July 1.
QUESTION What entries does GreenTea make in March and July 2025 to record
issuance and interest expense for the bonds?

LO 1
 Extinguishment of Debt
General Rule for extinguishment of debt
The difference between the reacquisition price over
net carrying amount is a gain or loss from
extinguishment (IS)*.
*Amortize premium or discount to the date of retirement
Illustration: On January 1, 2010, General Bell Corp. issued at 95
bonds with a par value of $800,000, due in 20 years. Eight years
after the issue date, General Bell calls the entire issue at 101 and
cancels it. At that time, the unamortized discount balance is
$24,000. General Bell computes the loss on redemption as follows.

14-11
 Extinguishment of Debt

General Bell records the reacquisition and cancellation of the

bonds as follows:

Bonds Payable 800,000

Loss on Redemption of Bonds 32,000
Discount on Bonds Payable 24,000
Cash 808,000

14-12
14-13
Zero-Interest-Bearing Notes
FACTS Turtle Cove Company issued the 3 -year, $10,000, zero-
interest-bearing note to Jeremiah Company illustrated in
Chapter 6 (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%. (The present value of $1 for 3 periods at 9% is
$0.77218.)
QUESTION What is the entry to record issuance of the note?
Cash
Discount on Notes Payable
Notes Payable

Interest Expense ($7,721.80 x .09) 694.96

Discount on Notes Payable 694.96
LO 3
Special Notes Payable Situations
Notes Issued for Property, Goods, or Services
When exchanging the debt instrument for property,
goods, or services in a bargained transaction, 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 face amount is materially different from the
current cash price for the same or similar items or
from the current fair value of the debt instrument.

LO 3
Note Issued for Goods or Services
Illustration:
FACTS Scenic Development Company sells land having a cash sale price of $200,000 to Health Spa, Inc. In
exchange for the land, Health Spa gives a 5-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% for 5 years.

QUESTIONS (a) Should both parties record the transaction on the sale date at the face amount of the note,
which is $293,866? Explain. (b) What entries do Health Spa and Scenic Development make at the exchange date?

SOLUTION

a. No. If they did, Health Spa’s Land account and Scenic’s sales would be overstated by $93,866 (the interest
for 5 years at an effective rate of 8%). Similarly, interest revenue to Scenic and interest expense to Health
Spa for the 5-year period would be understated by $93,866.
b. Given that 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%, the transaction is recorded as follows.

Health Spa, Inc. (Buyer) Scenic Development Company (Seller)

Land 200,000 Notes Receivable 293,866
Discount on Notes Payable 93,866 Discount on Notes Receivable 93,866
Notes Payable 293,866 Sales Revenue 200,000

LO 3
Reporting and Analyzing Liabilities
Fair Value Option
Companies have the option to record fair value in
their accounts for most financial assets and liabilities,
including bonds and notes payable.

LO 4
 Fair Value Option
FACTS Edmonds Company has issued $500,000 of 6% bonds at face value on May 1,
2025. Edmonds chooses the fair value option for these bonds. At December 31,
2025, the value of the bonds is now $480,000 because interest rates in the market
have increased to 8%.

Assume that the Edmonds Company fair value change on its bonds is due to its
credit rating dropping from AA to BB.

LO 4
Long-Term Debt Disclosure –Target Corp
19. Notes Payable and Long-Term Debt (in part)
At February 1, 2020, the carrying value and maturities of our debt portfolio
were as follows:
Debt Maturities February 1,2020
(millions) Rate(a) Balance
Due 2020–2024 3.8% $ 2,205
Due 2025–2029 3.3 2,180
Due 2030–2034 4.2 1,305
Due 2035–2039 6.8 1,109
Due 2040–2044 4.0 1,466
Due 2045–2049 3.7 1,727
Total notes and debentures 4.1 9,992
Swap valuation adjustments 137
Finance lease obligations 1,370
Less: Amounts due within one year (161)
Long-term debt and other borrowings $11,338

(a) Reflects the weighted average stated interest rate as of year-end.

Required principal payments on notes and debentures over the next five years are as follows:
Required Principal Payments
(millions) 2020 2021 2022 2023 2024
Total required principal payments $94 $1,056 $63 $---- $1,000 LO 4
 Debt Ratios
1. Amount of debt.

2. Indicates the company’s ability to meet interest payments as

they come due.

Cash from operations before cash interest and cash taxes

Coverage ratio 
Cash interest

LO 4
Analysis of Long-Term Debt
Illustration: Target has total liabilities of $30,946 ($14,487 +
$16,459) million, total assets of $42,779 million, interest
expense of $477 million, income taxes of $921 million, and
income from continuing operations of $3,281 million. We
compute Target’s debt to total assets and times interest earned
ratios as follows.

7,099+492+696 5,970+476+373
Cash Coverage = 492 =16.8 476 =14.3

LO 4
Troubled-Debt Restructurings
Troubled-debt restructuring occurs when a creditor “for
economic or legal reasons related to the debtor’s financial
difficulties grants a concession to the debtor that it would not
otherwise consider.”

Involves one of two basic types of transactions:

1. Settlement of debt at less than its carrying amount.
2. Continuation of debt with a modification of terms.

LO 5
Troubled-Debt Restructurings
Settlement of Debt
Can involve either a
• transfer of noncash assets (real estate, receivables, or
other assets) or
• the issuance of the debtor’s stock.
Creditor should account for the noncash assets or equity
interest received at their fair value.

LO 5
Illustration (Transfer of Assets): American City Bank loaned
$20,000,000 to Union Mortgage Company. Union Mortgage cannot
meet its loan obligations. American City Bank agrees to accept from
Union Mortgage real estate with a fair value of $16,000,000 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 Union Mortgage.

The creditor records this transaction as follows.

Land 16,000,000
Allowance for Doubtful Accounts (w/o) 4,000,000
Note Receivable (from Union Mortgage) 20,000,000

The debtor records this transaction as follows.

Note Payable (to American City Bank) 20,000,000
Loss on Disposal of Land 5,000,000
Land 21,000,000
Gain on Restructuring of Debt 4,000,000
Troubled Debt: (Granting an Equity Interest): American City Bank
agrees to accept from Union Mortgage 320,000 shares of common
stock ($10 par) that has a fair value of $16,000,000, in full settlement
of the $20,000,000 loan obligation.
The creditor records this transaction as follows.
Equity Investment 16,000,000
Allowance for Doubtful Accounts (w/o) 4,000,000
Note Receivable (from Union Mortgage) 20,000,000

The debtor records this transaction as follows.

Note Payable (to American City Bank) 20,000,000

Common Stock 3,200,000
Paid-in Capital in Excess of Par-Common 12,800,000
Gain on Restructuring of Debt 4,000,000
2. MODIFICATION OF TERMS

A debtor’s serious short-run cash flow problems will lead it to

request 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.
Example 1—No Gain for Debtor: On December 31, 2016, the bank
restructures a $10,500,000 loan receivable issued at par (interest paid
to date) by:
1. Reducing the principal obligation from $10,500,000 to
$9,000,000;
2. Extending the maturity date from December 31, 2016, to
December 31, 2020; and
3. Reducing the interest rate from 12% to 8%.
The total future cash flow* = $11,880,000 1. If positive, no
entry by debtor
Pre-restructure carrying amount = 10,500,000 on date of
Excess = $1,380,000 restructuring

*$9,000,000 of principal plus $2,880,000 of interest

 2. Need to solve for new effective rate that solves the following schedule!!!

Dec. 31, Notes Payable 356,056

2017 Interest Expense 363,944
Cash 720,000

Dec. 31, Notes Payable 9,000,000

2020 Cash 9,000,000
 Creditor Calculations Morgan National Bank (creditor)

1. Use Historical market interest

rate.

The creditor records bad debt expense as follows:

Bad Debt Expense 2,593,428

Allowance for Doubtful Accounts 2,593,428
Creditor Calculations

Morgan reports
interest revenue
based on the
historical effective
rate.

Dec. 31, 2017

Cash 720,000
Allowance for Doubtful Accounts 228,789
Interest Revenue 948,789
Dec. 31, 2020
Cash 9,000,000
Allowance for Doubtful Accounts 1,500,000
Notes Receivable 10,500,000
 Example 2—Gain for Debtor: Assume the facts in the previous example except
that Morgan National Bank
1. Reducing the principal obligation from $10,500,000 to $7,000,000 (rather
than $9,000,000);
2. Extending the maturity date from December 31, 2016, to December 31, 2020;
and
3. Reducing the interest rate from 12% to 8%.
1. If negative, need
entry by debtor on
The total future cash flow* = $ 9,240,000 date of restructuring
Pre-restructure carrying amount = 10,500,000
2. No future interest
Gain = ($1,260,000) expense, payments reduce
*$7,000,000 of principal plus $2,240,000 of interest carrying value

Under these circumstances, the debtor reduces the carrying amount of its payable
$1,260,000 and records a gain of $1,260,000. On the other hand, the creditor debits
its Bad Debt Expense for $4,350,444 (next page).
Example 2 - Gain for Debtor: The creditor computes Bad Debt
Expense of $4,350,444, as follows:
1. Use Historical market interest
rate.
Example 2—Gain for Debtor: Morgan National reports interest
revenue the same as the previous example
Example 2—Gain for Debtor): Accounting for periodic interest
payments and final principal payment.