Chapter 1

:

Accounting for Financial Liabilities

Objectives
1.
2.

3.
4. 5.

To describe long-term liabilities and describe how they are valued To identify the nature and types of long-term liabilities-bond To explain the methods of bond discount and premium amortization To prepare the related journal entries To describe the accounting treatment other long term liabilities

Long-Term Debt

Consists of present obligations not payable within the operating cycle of the business, or a year whichever is longer. Long-term creditors have no vote in management affairs and only receive a stated rate of interest regardless of the level of earnings. Covenants or restrictions, for the protection of both lenders and borrowers, are stated in the bond indenture or note agreement.

Bonds Payable

Arises from a contract known as a bond indenture. Represents a promise to pay the principle at maturity and periodic interest based on the stated interest rate and the face value of the bond the different types of bonds such as term bonds, serial bonds, secured and unsecured bonds, convertible bonds, commodity-backed bonds, deep discount bonds, registered, and coupon bonds.

with interest payable semiannually.1: Issuance of Bonds  Ghostbusters Corporation issues RM300. Compute the issue price of the bonds. the market rate for such bonds is 10%. At the time of issue. due in 10 years. .000 of 9% bonds.Exercise 5.

37689 PVOA of interest payable: [(9% x 300.067 168.307 .1  n = 10 x 2 i = 10%/2 PV of the principal: 300.240 281.Solution for Exercise 5.46221 Price of bond 113.000)/2] x 12.000 x 0.

d) If the stated rate > the market rate.Valuation of Bonds Payable  The price of a bond is determined by the interaction between the bond's stated interest rate and its market rate. . c) If the stated rate < the market rate. a) A bond's price is equal to the sum of the present value of the principle and the present value of the periodic interest. the bond will sell at a discount. the bond will sell at a premium. b) If the stated rate = the market rate. the bond will sell at par.

When a bond sells at a discount. the difference between the sales price and the face value is debited to Discount on Bonds Payable.Accounting for the Issuance of Bonds 1.  This is a contra-account to Bonds Payable. 2. The face value of the bond is always reflected in the bond payable account. .

ii. The price includes the interest accrued since the last interest payment. The accrued interest is credited to Bond Interest Expense. Bonds sold between interest dates. 4. .Accounting for the Issuance of Bonds (cont. the difference between the sales price and the face value is credited to Premium on Bonds Payable.) 3. i. When a bond sells at a premium.  This is an adjunct account to Bonds Payable.

The bonds are due on 1 Jan 2005.000 of 8% bonds on 1 Jan 2000.Exercise 5. with interest payable each 1 July and 1 Jan.2: Bonds Payable The Goofy Company issued RM200. Compute the issue price at a) 100 b) 97 c) 105 Prepare journal entries for both investee and investor .

2 at 100 Investee: (‘000) Dt Cash 200 Kt Bonds Payable 200 Investor: Dt Investment Kt Cash at 97 Investee: (‘000) Dt Cash 194 Dt Disc. bonds 6 Kt Bonds Payable 200 Investor: Dt Investment Kt Cash 194 194 at 105 Investee: (‘000) Dt Cash 210 Kt Bonds Payable 200 Kt Premium Bonds 10 Investor: Dt Investment Kt Cash 210 210 200 200 .Solution for Exercise 5.

Amortization of bond discounts and premiums Two methods: 1. . Effective interest method  is the preferred procedure used to calculate periodic interest expense. 2. Straight-line method  may be used if the results are not materially different from those produced by the effective interest method. The carrying amount of the bonds at the start of the period is multiplied by the effective interest rate to determine the interest expense.

If a premium exists: Dr Interest Expense Dr Premium on Bonds Payable Cr Interest Payable If a discount exists: Dr Interest Expense Cr Discount on Bonds Payable Cr Interest Payable XX XX XX XX XX XX  .Effective interest method     Carrying Value of Bonds = Face Value Plus Premium (or Less Discount). Interest Payable = Stated Interest Rate <> Face Value of Bonds. Interest Expense = Effective Interest Rate <> Carrying Value of Bonds.

at 102.3: Amortization of Bonds Payable Donald Duck Company issued RM600. Interest is payable semiannually on 1 July and 1 Jan. 20-year bonds on 1 Jan 2002. Prepare the journal entries to record: a)The issuance of the bonds b)The payment of interest on 1 July c)The accrual of interest on 31 Dec .000 of 10%. Donald Duck Company uses straight-line method of amortization for bond premium/discount.Exercise 5.

000 b) .700 300 30.000 12.3 a) Issuance of bonds Dr Cash (600.000 600.02) Cr Bonds Payable Cr Premium on bond Payment of interest on July 1 Dr Interest expense Dr Premium on bond p/able Cr Cash 612.000 29.000 x 1.Solution for Exercise 5.

3 (cont. 29.000 .Solution for Exercise 5.700 300 30.) c) Accrual interest on 31 Dec Dr Interest expense Dr Premium on bond p/able Cr. Account payable 1 Jan 2003 Dr Cr.

Interest is payable semiannually on 1 July and 1 Jan. Assume an effective rate yield of 11.Exercise 5.5% Prepare the journal entries to record: a)The issuance of the bonds b)The payment of interest on 1 July c)The accrual of interest on 31 Dec . Mickey Mouse Company uses effective interest method of amortization for bond premium/discount.4: Amortization of Bonds Payable Mickey Mouse Company issued RM600.000 of 10%. 10-year bonds on 1 Jan 2002.

000 x 15.000 x 0.4 a) Mickey Mouse (Issuance of bonds) i=11.5330 Price on 1 Jan = 64.900 600.Solution for Exercise 5.990 = 530.110 = 465.100 69. n=10x2 PV 600.100 Dr Cash Dr Discount on bond Cr Bonds payable 530.10685 PVOA 30.000 .5/2.

000 30.627 * 11.481* 30.000 = 481 *** 530.5% x 530.100 530.089 531.508 30538 Amort.481 ** 30.000 Balance of Bonds 530. Disc 481** 508 538 1 2 3 30.100 + 481 = 530.000 30.100 x 6/12 = 30. 30.4 (cont.) Cash Interest exp.581 .481 – 30.581*** 531.Solution for Exercise 5.

4 (cont.) b) b) Interest expense on 1 July Dr Interest expense Cr discount on bond Cr.000 .000 30. Cash Interest expense on 1 Jan Dr Interest expense Cr discount on bond Cr. Interest payable 30.Solution for Exercise 5.508 508 30.481 481 30.

administrative expense (printing doc/prospectus). underwriting fees.Cost of Bonds Issue  The issue of bonds involve numerous costs:  Legal and accounting expense. 2.   These costs do NOT represent an asset Methods of recognition: 1. As an expense – charge to income statement immediately As a liability – debited to a deferred charge account .

5: Cost of Bond Issue  Assume that Cyber Bhd issued a RM40.000.Exercise 5.000 five-year bond at its par value on 1 January 1999.000. The bond carries a coupon interest of 10% and interest is payable on 31 Dec each year. The costs were capitalized as a deferred charge and amortized on the straight line method.000. totaled RM1. which included underwriting fees. Costs of issuing the bond. Show the entries to (a) record the issue of bond on 1 Jan 1999 (b) recognize the amortization of the bond issue cost and interest expense .

000 Journal entry to recognize interest expense Dt Interest expense 4.000 Kt Bonds Payable 40.Solution for Exercise 5.000 Kt Cash 4.000 .5 a) Journal entry to record the issuance of the bond Dt Cash 39.000 Dt Deferred bond 1.000.000 Kt Deferred bond 200.000.000 b) c) Journal entry to recognize amortization of deferred charge Dt Amortization expense 200.000.000.000.

 Price of bonds is the present value of the bond at the date of selling/buying.  Accrued interest is calculated for the period in between of the date of previous interest payment with date of bond is sold.  Cash paid by buyer is the price of the bonds together with the accrued interest.ISSUE OF BONDS IN BETWEEN OF TWO INTEREST DATES Adjustment for accrued interest should be done.  .

1999 June 30. The following is the information on the bond. 1999 Dec 31 and June 30 Date of bond Maturity date Date of selling the bond Date of interest payment Stated interest rate Face value of bond  9% RM200.Exercise 5.000 Prepare journal entries on 1 Sept and 31 Dec .6  Cumi Bhd purchased bond from Ciki Bhd. June 30. 2004 Sept 1.

000) 200.91272 x 9.6 Issued at par Effective interest rate = 9% Price of bond Face value [PV4.000 (3.000 3.Solution for Exercise 5. 10 200.000 x 9% x 2/12] Cash (-) Cash paid for interest from 30/6 – 1/9 [200.000 = 7.000 .786 71.000] Interest [PVOA4.000 203.64393 x 200.5%.214 200. 10 9.5%.000 = 0.000 x 9% x 2/12] PRICE OF BOND AT 1/9/99 128.000] Present Value (+) Increment of bond’s value from 30/6 – 1/9 [200.

200. Sept 1 Dr Investment Bonds 200.000 x 9% x 2/12 Dec.000 200.000 (interest) 200.000 Cr Cash 203.6 (cont.0001 Cr Cash 9.000 Dec.) Journal entries Sept 1 Dr Cash 203. 2.000 x 9% x 4/12 .000 Interest Receivable 3.000 Cr Interest Revenue 6.000 Interest Expense 6.Solution for Exercise 5. 31 Dr Interest Payable 3.0002 Bonds Payable 200.000 Interest Receivable 3.000 1.0001 Cr Interest Payable 3. 31 Dr Cash 9.000 1.000 + 3.

315 (3.58543 x 200.000 = 0.5%.315 .925 x 11% x 2/12] Cash (-) Cash paid for interest from 30/6 – 1/9 [200.839 184.000] Interest [PVOA5.000 = 7.390 188.53763 x 9.925 3.000 x 9% x 2/12] PRICE OF BOND AT 1/9/99 117. 10 200.6 (cont.000] Present Value (+) Increment of bond’s value from 30/6 – 1/9 [184.) Issued at discount Effective interest rate = 11% Price of bond Face value [PV5.5%. 10 9.Solution for Exercise 5.000) 185.086 67.

000 Cr Interest Payable 3.000 1.6 (cont.Solution for Exercise 5.315 Bonds Payable 200.6852 Interest Receivable 3.000 x 9% x 2/12 .315 + 3. 185. 200.) Journal entries Sept 1 Sept 1 Dr Cash 188. 200.315 3.000 (interest) 2.0003 Cr Cash 188.3151 Dr Investment Bonds 185.315 Disc on Bond 14.000 – 185.

235 1.000 9.000 10.905 12.6 (cont.075 13.171 10.) Date Cash Paid Interest Amortisati on of Expense discount Discount not amortised Carrying amount of bond 30/6 31/12 30/6 9.331 .171 1.Solution for Exercise 5.669 184.235 15.096 187.925 186.

31 Dr Interest Expense 6.000 Cash 9.Solution for Exercise 5.) Dec.000 Interest Receivable 3.171 – (3.171 x 4/6 2.000 1.185. 31 Dec. 1. 10.171 x 4/6.781 Cash 9.315 or = 1.000 Cr Disc on Bonds 7812 Cr Interest Revenue 6.7811 Dr Investment in Bonds 781 Interest Payable 3.390-3.6 (cont.000) . OR: = 186.096 .

no profit or loss is recorded Carrying Amount of Bond = Face Value of Bond  Journal entry for payment made at the maturity date: Dr Bonds Payable XX Interest Payable XX Cr Cash XX Discounts on Bonds Payable XX . Callable Bond At the maturity date  If bond is retired at the maturity date. Converted Bond 3.RETIREMENT OF BONDS Before the maturity date  Examples of bonds retirement: 1. Refunding 2.

 Interest expense and amortisation of discount/premium needs to be recorded in advance until the retirement date.  . all records on bonds and any related records to the old bond will be eliminated.Refunding Bond is retired by issuing new bond.  At the retirement.

Example  On January 1.000. 1999. 20-year. Market interest rate is 8%. . with stated interest rate of 8% paid at the same dates. 1995. On January 1.000. Wira Company issued RM100. the buyer agreed to receive bond of RM90. 10-year bond at par and with stated interest rate of 5% paid every 30/6 and 31/12.

000 Cr Bonds Payable 100.000 (at par) 1/1/99 Dr Bonds Payable – 5% 100.000 Cr Bonds Payable – 8% 90.000  .000  At refunding Value of new issuance of bond = RM90.At the issuance of the bond: 1/1/95 Dr Cash 100.000 Cr Gains from retirement 10.

Book value method 2.Converted Bonds      Bonds can be converted into shares Reasons for conversion: to increase the share capital or to make the bond marketable Entries for issuing of the bonds – 2 methods: excess from sale as equity (separate between debts and equity) the excess is considered as debts (no separation between debts and equity)  Entries for converting bonds to shares:  2 methods: 1. Fair value method .

Book Value of the bonds  Gain/loss is considered as ordinary item in an Income Statement .Methods for Converted bonds a) BOOK VALUE METHOD  Record of share and premium at book value of bond at the conversion date  No gain/loss is recorded  If fair value of shares > book value of bond  there is a decrease in retained earnings b) FAIR VALUE METHOD  Shares and premium are recorded at fair value of the issued shares  Gain/loss is recognized  Gain/loss = Fair Value of the shares .

Book value method 2.000 bond convertible into 10 shares of ordinary shares (par value RM10). The market value of the bond is RM1. At the time of conversion the unamortised premium is RM 50. Fair value method .200 and the shares is quoted on the market at RM120.7: Converted Bonds   Tania Company issued at a premium of RM60 a Rm1. Record the journal entries using: 1.Exercise 5.

Book value method DR Bond payable 1.000 DR Premium on Bond Payable 50 CR Ordinary shares CR Premium shares 100 950 .

000 DR Premium on Bond Payable 50 DR Loss on Redemption of Bond 150 CR Ordinary shares 100 CR Premium shares 1100 .Fair Value Method DR Bond payable 1.

CAN be repaid at any time if it is called up. Normally the bond is callable when the market interest decline – refinance at lower rate At the callable date. it is retired.Callable Bonds      Normally the bond is repaid at the maturity date. Thus. When the bond is callable. . the company should record all interest expense and amortise the discount/premium until that date. all record of the bonds and any related to it will be eliminated.

• Convertible Bonds (CULS) Debt securities that are exchangeable into ordinary shares at the option of the holder and under specified terms and conditions 2. • Warrants (Transferable Subscription Rights) Gives the holder right to subscribe specific number of shares at the pre-determine exercise price and within a specified period of time .Other Instrument for Long Term Liabilities 1.

Irredeemable Convertible Loan Stocks (ICULS) Quasi-debt – pay annual coupon over their tenure but ‘irredeemable’ in future. means there will be no repayment of principle at maturity  Mandatory converted  Faced value of ICULS will be converted into new ordinary shares based on stipulated conversion ratio  .Other Instrument for Long Term Liabilities (cont.) 3.

00 per ICULS. par)  Journal entries at issuance and conversion?  .00. Tom & Jerry Company issues RM1 million ICULS 2002/2006 value at RM1.9: ICULS On 1 Jan 2002. This ICULS can be converted into ordinary shares based on conversion ratio of RM5 ICULS for one new shares (RM1. The five-year ICULS paid 7.Exercise 5.5% coupon per year.

000 At Conversion (maturity date) RM1 million ICULS = # shares? New shares = 1.000.000 5 = 200.000 800.9 At Issuance DR Cash CR ICULS 1.000.000 units shares DR ICULS 1.Solution for Exercise 5.000 1.000.000.000 CR Ordinary shares CR Premium on shares 200.000 .