Kế toán tài chính - Long - Term liabilities

PREVIEW OF CHAPTER 14Intermediate Accounting16th EditionKieso ● Weygandt ● Warfield Describe the nature of bonds and indicate the accounting for bond issuances.Describe the accounting for the extinguishment of debt.Explain the accounting for long-term notes payable.LEARNING OBJECTIVESDescribe the accounting for the fair value option.Indicate how to present and analyze long-term debt.After studying this chapter, you should be able to:Long-Term Liabilities14LO 1Long-term debt consists of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Examples: Bonds payableLong-term notes payableMortgages payablePension liabilities Lease liabilitiesLong-term debt has various covenants or restrictions.BONDS PAYABLELO 1Bond contract known as a bond indenture.Represents a promise to pay: sum of money at designated maturity date, plusperiodic interest at a specified rate on the maturity amount (face value).Paper certificate, typically a $1,000 face value. Interest payments usually made semiannually. Used when the amount of capital needed is too large for one lender to supply.BONDS PAYABLEIssuing BondsLO 1Common types found in practice:Secured and Unsecured (debenture) bonds.Term, Serial, and Callable bonds.Convertible, Commodity-Backed, Deep-Discount bonds.Registered and Bearer (Coupon) bonds.Income and Revenue bonds.Types of BondsBONDS PAYABLELO 1Types of BondsCorporate bond listing.Company NameInterest rate paid as a % of par valuePrice as a % of parInterest rate based on priceFace and maturity valueMaturity dateLO 1Valuation and Accounting for Bonds PayableIssuance and marketing of bonds to the public:Usually takes weeks or months. Issuing company mustArrange for underwriters. Obtain SEC approval of the bond issue, undergo audits, and issue a prospectus.Have bond certificates printed. LO 1Selling price of a bond issue is set by the supply and demand of buyers and sellers, relative risk, market conditions, and state of the economy.Investment community values a bond at the present value of its expected future cash flows, which consist of (1) interest and (2) principal.Valuation and Accounting for BondsLO 1Interest RateStated, coupon, or nominal rate = Rate written in the terms of the bond indenture. Bond issuer sets this rate.Stated as a percentage of bond face value (par).Market rate or effective yield = Rate that provides an acceptable return commensurate with the issuer’s risk. Rate of interest actually earned by the bondholders.Valuation and Accounting for BondsLO 1How do you calculate the amount of interest that is actually paid to the bondholder each period?How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds?(Stated Rate x Face Value of the Bond)(Market Rate x Carrying Value of the Bond)Valuation and Accounting for BondsLO 1LO 1Bonds Sold AtMarket Interest6%8%10%PremiumPar ValueDiscountAssume Stated Rate of 8%Valuation and Accounting for BondsIllustration: ServiceMaster Company issues $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.Valuation and Accounting for BondsILLUSTRATION 14-1 Time Diagram for Bond Cash FlowsLO 1ILLUSTRATION 14-1Valuation and Accounting for BondsILLUSTRATION 14-2 Present Value Computation of Bond Selling at a DiscountLO 1LO 1Two major publication companies, Moody’s Investors Service and Standard & Poor’s Corporation, issue quality ratings on every public debt issue. The table to the right summarizes the ratings issued by Standard & Poor’s, along with historical default rates on bonds with different ratings.As expected, bonds receiving the highest quality rating of AAA have the lowest historical default rates. Bonds rated below BBB, which are considered below investment grade (“junk bonds”), experience default rates ranging from 20 to 50 percent. Debt ratings reflect credit quality. The market closely monitors these ratings when determining the required yield and pricing of bonds at issuance and in periods after issuance, especially if a bond’s rating is upgraded or downgraded. Unfortunately, the median rating of companies assessed by Standard & Poor’s has recently fallen from A to BBB.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? HOW’S MY RATING?(continued)LO 1The BBB rating is the lowest possible “investment grade” or, to put it another way, is just one notch above “junk” bond status. It should be noted that investors who seek triple-A debt are running out of options. Standard & Poor’s recently gave its top rating to just three U.S. industrial companies: ExxonMobil, Johnson & Johnson, and Microsoft. Indeed, the overall decline in ratings can be explained in part by the growing issuance of CCC-rated debt in a variety of industry sectors, as shown in the chart to the right. Years of low interest rates have encouraged some of the riskiest corporate borrowers to tap yield-hungry investors to finance their growth, spurring issuance of debt that comes with triple-C credit ratings. For investors willing to shoulder the burden of those extra risks in exchange for heftier returns, CCC-rated bonds have been alluring.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? HOW’S MY RATING?Illustration: Buchanan Company issues at par 10-year term bonds with a par value of $800,000, dated January 1, 2017, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the following entry.Bonds Issued at Par on Interest DateJournal entry on date of issue, Jan. 1, 2017. Cash 800,000 Bonds Payable 800,000LO 1Bonds Issued at Par on Interest DateJournal entry to record first semiannual interest payment on July 1, 2017. Interest Expense 40,000 Cash 40,000Journal entry to accrue interest expense at Dec. 31, 2017. Interest Expense 40,000 Interest Payable 40,000($800,000 x .10 x ½)LO 1Bonds Issued at Discount on Interest DateIllustration: If Buchanan Company issues $800,000 of bonds on January 1, 2017, at 97, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the issuance as follows. Cash ($800,000 x .97) 776,000 Discount on Bonds Payable 24,000 Bonds Payable 800,000Note: Assuming the use of the straight-line method, $1,200 of the discount is amortized to interest expense each period for 20 periods ($24,000 ÷ 20).LO 1 Interest Expense 41,200 Discount on Bonds Payable 1,200 Cash 40,000At Dec. 31, 2017, Buchanan makes the following adjusting entry.Illustration: Buchanan records the first semiannual interest payment and the bond discount on July 1, 2017, as follows. Interest Expense 41,200 Discount on Bonds Payable 1,200 Interest Payable 40,000Bonds Issued at Discount on Interest DateLO 1Bonds Issued at Premium on Interest DateIllustration: If Buchanan Company issues $800,000 of bonds on January 1, 2017, at 103, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the issuance as follows. Cash ($800,000 x 1.03) 824,000 Premium on Bonds Payable 24,000 Bonds Payable 800,000Note: With the bond premium of $24,000, Buchanan amortizes $1,200 to interest expense each period for 20 periods ($24,000 ÷ 20).LO 1 Interest Expense 38,800 Premium on Bonds Payable 1,200 Cash 40,000At Dec. 31, 2017, Buchanan makes the following adjusting entry.Illustration: Buchanan records the first semiannual interest payment and the bond premium on July 1, 2017, as follows. Interest Expense 38,800 Premium on Bonds Payable 1,200 Interest Payable 40,000Bonds Issued at Premium on Interest DateLO 1When companies issue bonds on other than the interest payment dates,Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue.On the next semiannual interest payment date, purchasers will receive the full six months’ interest payment.Bonds Issued Between Interest DatesLO 1Illustration: On March 1, 2017, Taft Corporation issues 10-year bonds, dated January 1, 2017, with a par value of $800,000. These bonds have an annual interest rate of 6 percent, payable semiannually on January 1 and July 1. Taft records the bond issuance at par plus accrued interest as follows.Bonds Issued Between Interest Dates Cash 808,000 Bonds Payable 800,000 Interest Expense ($800,000 x .06 x 2/12) 8,000LO 1On July 1, 2017, four months after the date of purchase, Taft pays the purchaser six months’ interest and makes the following entry.Bonds Issued Between Interest Dates Interest Expense 24,000 Cash 24,000LO 1If, however, Taft issued the 6 percent bonds at 102, its March 1 entry would be:Bonds Issued Between Interest Dates Cash 824,000 Bonds Payable 800,000 Premium on Bonds Payable ($800,000 x .02) 16,000 Interest Expense 8,000* [($800,000 x 1.02) + ($800,000 x .06 x 2/12)]*LO 1Produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds.Effective-Interest MethodAccounting for BondsILLUSTRATION 14-4 Bond Discount and Premium Amortization Computation LO 1Effective-Interest MethodBonds Issued at a DiscountIllustration: Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2017, due on January 1, 2022, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 10%. Calculate the bond proceeds.ILLUSTRATION 14-5Computation of Discount on Bonds PayableLO 1$100,000Face ValueFactorPresent Valuex .61391= $61,391TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)Effective-Interest MethodLO 1$4,000Semiannual PaymentFactorPresent Valuex 7.72173= $30,887TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1Effective-Interest MethodLO 1ILLUSTRATION 14-6LO 1Journal entry on date of issue, Jan. 1, 2017. Cash 92,278 Discount on Bonds Payable 7,722 Bonds Payable 100,000ILLUSTRATION 14-6LO 1 Interest Expense 4,614 Discount on Bonds Payable 614 Cash 4,000Journal entry to record first payment and amortization of the discount on July 1, 2017. LO 1ILLUSTRATION 14-6Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2017. Interest Expense 4,645 Interest Payable 4,000 Discount on Bonds Payable 645LO 1ILLUSTRATION 14-6Illustration: Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2017, due on January 1, 2022, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 6%. Calculate the bond proceeds.Bonds Issued at a PremiumEffective-Interest MethodILLUSTRATION 14-7Computation of Premium on Bonds PayableLO 1$100,000Face ValueFactorPresent Valuex .74409= $74,409TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)Effective-Interest MethodLO 1$4,000Semiannual PaymentFactorPresent Valuex 8.53020= $34,121TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1Effective-Interest MethodLO 1ILLUSTRATION 14-8LO 1ILLUSTRATION 14-8Journal entry on date of issue, Jan. 1, 2017. Cash 108,530 Premium on Bonds Payable 8,530 Bonds Payable 100,000LO 1 Interest Expense 3,256 Premium on Bonds Payable 744 Cash 4,000Journal entry to record first payment and amortization of the premium on July 1, 2017. LO 1ILLUSTRATION 14-8What happens if Evermaster prepares financial statements at the end of February 2017? In this case, the company prorates the premium by the appropriate number of months to arrive at the proper interest expense, as follows.Accrued InterestEffective-Interest MethodILLUSTRATION 14-9Computation of Interest ExpenseLO 1Evermaster records this accrual as follows.Effective-Interest Method Interest Expense 1,085.33 Premium on Bonds Payable 248.00 Interest Payable 1,333.33ILLUSTRATION 14-9Accrued InterestLO 1Companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond.Effective-Interest MethodClassification of Discount and PremiumLO 1Describe the nature of bonds and indicate the accounting for bond issuances.Describe the accounting for the extinguishment of debt.Explain the accounting for long-term notes payable.LEARNING OBJECTIVESDescribe the accounting for the fair value option.Indicate how to present and analyze long-term debt.After studying this chapter, you should be able to:Long-Term Liabilities14LO 2Illustration: 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.Extinguishment of DebtILLUSTRATION 14-11Computation of Loss on Redemption of BondsLO 2Extinguishment of DebtBonds Payable 800,000Loss on Redemption of Bonds 32,000 Discount on Bonds Payable 24,000 Cash 808,000General Bell records the reacquisition and cancellation of the bonds as follows:LO 2LO 2Traditionally, investors in the equity and bond markets operate in their own separate worlds. However, in recent volatile markets, even quiet murmurs in the bond market have been amplified into movements (usually negative) in share prices. At one extreme, these gyrations heralded the demise of a company well before the investors could sniff out the problem. The swift decline of Enron in late 2001 provided the ultimate lesson: A company with no credit is no company at all. As one analyst remarked, “You can no longer have an opinion on a company’s shares without having an appreciation for its credit rating.” Indeed, other energy companies also felt the effect of Enron’s troubles as lenders tightened or closed down the credit supply and raised interest rates on already-high levels of debt. The result? Stock prices took a hit. Other industries are not immune from the negative shareholder effects of credit problems. For example, analysts at TheStreet.com compiled a list of companies with a focus on debt levels. Companies like Copel CIA (an energy distribution company) were rewarded with improved stock ratings, based on their manageable debt levels.Or consider the case of Apple, which recently issued a whopping $6.5 billion of debt while its stock continued to perform well. The reason? Apple is reportingWHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? YOUR DEBT IS KILLING MY EQUITY(continued)LO 2strong profitability and good cash flows, so there is little concern that it cannot meet its debt obligations. In contrast, other companies with high debt levels and low ability to cover interest costs were not viewed very favorably. Among them are Herbalife and Goodyear Tire and Rubber, the latter of which reported debt levels several times greater than its equity. Goodyear is a classic example of how swift and crippling a heavy debt-load can be. Not too long ago, Goodyear had a good credit rating and was paying a good dividend. But, with mounting operating losses, Goodyear’s debt became a huge burden, its debt rating fell to junk status, the company cut its dividend, and its stock price dropped 80 percent. Only recently has Goodyear been able to dig out of its debt ditch. This was yet another example of stock prices taking a hit due to concerns about credit quality. Thus, even if your investment tastes are in equity, keep an eye on the liabilities.Sources: Adapted from Steven Vames, “Credit Quality, Stock Investing Seem to Go Hand in Hand,” Wall Street Journal (April 1, 2002), p. R4; Herb Greenberg, “The Hidden Dangers of Debt,” Fortune (July 21, 2003), p. 153; Christine Richard, “Holders of Corporate Bonds Seek Protection from Risk,” Wall Street Journal (December 17–18, 2005), p. B4; and S. Nielson, “Ackman Says Herbalife’s Debt Levels Are Cause for Concern,” (December 29, 2014).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? YOUR DEBT IS KILLING MY EQUITYDescribe the nature of bonds and indicate the accounting for bond issuances.Describe the accounting for the extinguishment of debt.Explain the accounting for long-term notes payable.LEARNING OBJECTIVESDescribe the accounting for the fair value option.Indicate how to present and analyze long-term debt.After studying this chapter, you should be able to:Long-Term Liabilities14LO 3LONG-TERM NOTES PAYABLEAccounting for notes and bonds is quite similar.A note is valued at the present value of its future interest and principal cash flows. Company amortizes any discount or premium over the life of the note.LO 3Illustration: Scandinavian Imports issues a $10,000, three-year note, at face value to Bigelow Corp. The stated rate and the effective rate were both 10 percent. Scandinavian would record the issuance of the note as follows.Notes Issued at Face Value Cash 10,000 Notes Payable 10,000 Interest Expense 1,000 Cash 1,000 ($10,000 x 10% = $1,000) Scandinavian Imports would recognize the interest incurred each year as follows.LO 3Notes Not Issued at Face ValueIssuing company records the difference between the face amount and the present value (cash received) asa discount and amortizes that amount to interest expense over the life of the note. Zero-Interest-Bearing NotesLO 3Illustration: Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Company. 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.Zero-Interest-Bearing NotesILLUSTRATION 14-12Time Diagram for Zero-Interest-Bearing NoteLO 3Zero-Interest-Bearing NotesCash 7,721.80Discount on Notes Payable 2,278.20 Notes Payable 10,000.00Illustration: Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Company. 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. Turtle Cove records issuance of the note as follows.LO 3Interest Expense 694.96 Discount on Notes Payable 694.96Turtle Cove records interest expense at the end of the first year as follows.ILLUSTRATION 14-13Schedule of Note Discount AmortizationLO 3Interest-Bearing NotesCash 9,520Discount on Notes Payable 480 Notes Payable 10,000Illustration: Marie Co. issued for cash a $10,000, three-year note bearing interest at 10 percent to Morgan Corp. The market rate of interest is 12 percent and the stated rate is 10%. The present value of the note is calculated to be $9,520. Marie Co. records the issuance of the note as follows.LO 3Interest Expense 1,142 Discount on Notes Payable 142 Cash 1,000Prepare the entry required at the end of the first year.ILLUSTRATION 14-14Schedule of Note Discount AmortizationLO 3Notes Issued for Property, Goods, or ServicesSpecial Notes Payable SituationsNo interest rate is stated, orThe stated interest rate is unreasonable, orThe 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.When exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless:LO 3If a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, company must approximate an applicable interest rate.Special Notes Payable SituationsChoice of rate is affected by:Prevailing rates for similar instruments. Factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.Choice of Interest RatesLO 3Special Notes Payable SituationsIllustration: On December 31, 2017, Wunderlich Company issued a promissory note to Brown Interiors Company for architectural services. The note has a face value of $550,000, a due date of December 31, 2022, and 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.LO 3Special Notes Payable SituationsILLUSTRATION 14-16 Time Diagram for Interest-Bearing NoteILLUSTRATION 14-17Computation of Imputed Fair Value and Note DiscountLO 3Special Notes Payable SituationsWunderlich records issuance of the note on Dec. 31, 2017, in payment for the architectural services as follows.Building (or Construction in Process) 418,239Discount on Notes Payable 131,761 Notes Payable 550,000LO 3Payment of first year’s interest and amortization of the discount.Interest Expense 33,459 Discount on Notes Payable 22,459 Cash 11,000ILLUSTRATION 14-18LO 3A promissory note secured by a document called a mortgage that pledges title to property as security for the loan.Mortgage Notes PayableMost common form of long-term notes payable.Payable in full at maturity or in installments.Fixed-rate mortgage. Variable-rate mortgages.LO 3Describe the nature of bonds and indicate the accounting for bond issuances.Describe the accounting for the extinguishment of debt.Explain the accounting for long-term notes payable.LEARNING OBJECTIVESDescribe the accounting for the fair value option.Indicate how to present and analyze long-term debt.After studying this chapter, you should be able to:Long-Term Liabilities14LO 4LONG-TERM NOTES PAYABLECompanies have the option to record fair value in their accounts for most financial assets and liabilities, including bonds and notes payable. The FASB believes that fair value measurement for financial instruments, including financial liabilities, provides more relevant and understandable information than amortized cost.Fair Value OptionLO 4Fair Value OptionNon-current liabilities are recorded at fair value, with unrealized holding gains or losses reported as part of net income.Fair Value MeasurementIllustrations: Edmonds Company has issued $500,000 of 6 percent bonds at face value on May 1, 2017. Edmonds chooses the fair value option for these bonds. At December 31, 2017, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent.Bonds Payable 20,000 Unrealized Holding Gain or Loss—Income 20,000LO 4LO 4The move to change the accounting for financial liabilities under the fair value option began in 2011, when Citigroup’s third-quarter earnings rose 68 percent from a year earlier, partly due to an accounting adjustment. The accounting adjustment was a $1.9 billion gain related to a change in the valuation of its debt obligations. A similar situation resulted in the third quarter of 2011 for JPMorgan. Its results were enhanced by decreasing the value of its debt, also by $1.9 billion. Some wondered how these banks’ net incomes increased even though their credit ratings declined. This result seems counterintuitive—how does a company that is actually doing worse have its income increase? Well, at that time, fair value adjustments for liabilities under the fair value option were recorded in income, rather than in OCI. As one expert noted, “At its worse, bank accounting can seem like the mirrors in a fun house. Reality is reflected, but the distortions can be large.” So what to do? Three different viewpoints were suggested. One view was that changes in the value of the liability should not be reported in income until the liability is extinguished. Those who supported this position believe that theWHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? FAIR VALUE FUN HOUSE(continued)LO 4information related to reporting value changes in the liability in income (or comprehensive income) was misleading and not useful to financial statement users. Others argued that reporting the unrealized gains and losses related to changes in the fair value of the liability through net income was appropriate given many financial assets could also be reported at fair value. A third group agreed with the fair value approach but indicated that if the change in value was a result of a change in credit risk the unrealized gain or loss should be reported as other comprehensive income. As indicated in our discussion related to the accounting for the fair value option related to financial liabilities, the FASB now requires that the unrealized gains and losses related to changes in a company’s own credit risk be reported in other comprehensive income. This approach has the benefit of reducing the volatility in net income for preparers. In addition, GAAP and IFRS are now converged with respect to the accounting for liability changes arising from credit risk.Sources: Floyd Norris, “Distortions in Baffling Financial Statements,” The New York Times (November 10, 2011); and Marie Leone, “The Fair Value Deadbeat Debate Returns,” CFO.com (June 25, 2009).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? FAIR VALUE FUN HOUSEDescribe the nature of bonds and indicate the accounting for bond issuances.Describe the accounting for the extinguishment of debt.Explain the accounting for long-term notes payable.LEARNING OBJECTIVESDescribe the accounting for the fair value option.Indicate how to present and analyze long-term debt.After studying this chapter, you should be able to:Long-Term Liabilities14LO 5Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations.REPORTING AND ANALYZING LIABILITIESDifferent FormsNon-Consolidated SubsidiarySpecial-Purpose Entity (SPE)Operating LeasesOff-Balance-Sheet FinancingLO 5Off-Balance-Sheet FinancingRationaleRemoving debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost.Loan covenants often limit the amount of debt a company may have. These types of commitments might not be considered in computing the debt limitation.Some argue that the asset side of the balance sheet is severely understated.LO 5LO 5The off-balance-sheet world is slowly but surely becoming more on-balance-sheet. New interpretations on guarantees (discussed in Chapter 13) and variable-interest entities (discussed in Appendix 17B) are doing their part to increase the amount of debt reported on corporate balance sheets. In addition, the SEC has rules that require companies to 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. Companies now must include a tabular disclosure (following a prescribed format) in the management discussion and analysis section of the annual report. Presented next is Best Buy Co.’s tabular disclosure of its contractual obligations.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? OBILIGATED(continued)LO 5LO 5Enron’s 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 in the accounting profession are now providing increased guidance on companies’ reporting of contractual obligations. We believe the SEC rule, which requires companies to report their obligations over a period of time, will be extremely useful to the investment community.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? OBILIGATEDNote 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.Fair value of the debt should be disclosed.Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.Presentation of Long-Term DebtLO 5Two ratios that provide information about debt-paying ability and long-run solvency are:Total liabilitiesTotal assets Debt to assets ratio =The higher the percentage of liabilities to total assets, the greater the risk that the company may be unable to meet its maturing obligations.Analysis of Long-Term Debt1.LO 5Two ratios that provide information about debt-paying ability and long-run solvency are:Income before income taxes and interest expenseInterest expense =Indicates the company’s ability to meet interest payments as they come due.Times interest earned2.Analysis of Long-Term DebtLO 5Illustration: Target has total liabilities of $27,407 million, total assets of $41,404 million, interest expense of $882 million, income taxes of $1,204 million, and income from continuing operations of $2,449 million. We compute Target’s debt to total assets and times interest earned ratios as follows.Analysis of Long-Term DebtILLUSTRATION 14-22Computation of Long-Term Debt Ratios for TargetLO 5Troubled-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:Settlement of debt at less than its carrying amount.Continuation of debt with a modification of terms.TROUBLED-DEBT RESTRUCTURINGAPPENDIX 14AILLUSTRATION 14A-1Usual Progression in Troubled-Debt SituationsLO 6 Describe the accounting for a debt restructuring. SETTLEMENT OF DEBTCan 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.TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Illustration (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. American City Bank (creditor) records this transaction as follows.Land 16,000,000Allowance for Doubtful Accounts 4,000,000 Note Receivable (from Union Mortgage) 20,000,000TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Illustration (Transfer of Assets): The bank records the real estate at fair value. Further, it makes a charge to the Allowance for Doubtful Accounts to reflect the bad debt write-off. Union Mortgage (debtor) records this transaction as follows.Note Payable (to American City Bank) 20,000,000Loss on Disposal of Land 5,000,000 Land 21,000,000 Gain on Restructuring of Debt 4,000,000TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Illustration (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. American City Bank (creditor) records this transaction as follows.Equity Investment 16,000,000Allowance for Doubtful Accounts 4,000,000 Note Receivable (from Union Mortgage) 20,000,000TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Illustration (Granting an Equity Interest): It records the stock as an investment at the fair value at the date of restructure. Union Mortgage (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 4,000,000TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6MODIFICATION OF TERMSA debtor’s serious short-run cash flow problems will lead it to request one or a combination of the following modifications:Reduction of the stated interest rate.Extension of the maturity date of the face amount of the debt.Reduction of the face amount of the debt.Reduction or deferral of any accrued interest.TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Illustration (Example 1—No Gain for Debtor): On December 31, 2016, Morgan National Bank enters into a debt restructuring agreement with Resorts Development Company, 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, 2016, to December 31, 2020; andReducing the interest rate from 12% to 8%.TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Notes Payable 356,056Interest Expense 363,944 Cash 720,000Dec. 31, 2017TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14AILLUSTRATION 14A-2Schedule Showing Reduction of Carrying Amount of NoteLO 6Notes Payable 9,000,000 Cash 9,000,000Dec. 31, 2020TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14AILLUSTRATION 14A-2Schedule Showing Reduction of Carrying Amount of NoteLO 6Creditor Calculations Morgan National Bank (creditor)Morgan National Bank records bad debt expense as follows:Bad Debt Expense 2,593,428 Allowance for Doubtful Accounts 2,593,428TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14AILLUSTRATION 14A-3 Computation of Loss to Creditor on RestructuringLO 6Morgan reports interest revenue based on the historical effective rate.Cash 720,000Allowance for Doubtful Accounts 228,789 Interest Revenue 948,789Dec. 31, 2017TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ACreditor CalculationsILLUSTRATION 14A-4Schedule of Interest and Amortization after Debt RestructuringLO 6The creditor makes a similar entry (except for different amounts debited to Allowance for Doubtful Accounts and credited to Interest Revenue) each year until maturity. At maturity, the company makes the following entry.Cash 9,000,000Allowance for Doubtful Accounts 1,500,000 Notes Receivable 10,500,000Dec. 31, 2020TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ACreditor CalculationsLO 6Illustration (Example 2—Gain for Debtor): Assume the facts in the previous example except that Morgan National Bank reduces the principal to $7,000,000 (and extends the maturity date to December 31, 2020, and reduces the interest from 12% to 8%). The total future cash flow is now $9,240,000 ($7,000,000 of principal plus $2,240,000 of interest), which is $1,260,000 ($10,500,000 - $9,240,000) less than the pre-restructure carrying amount of $10,500,000. Under these circumstances, Resorts Development (debtor) reduces the carrying amount of its payable $1,260,000 and records a gain of $1,260,000. On the other hand, Morgan National Bank (creditor) debits its Bad Debt Expense for $4,350,444.TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14ALO 6Illustration (Example 2—Gain for Debtor): Morgan (creditor) debits its Bad Debt Expense for $4,350,444.TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14AILLUSTRATION 14A-5Computation of Loss to Creditor on RestructuringILLUSTRATION 14A-6Debtor and Creditor Entries to Record Gain and Loss on NoteLO 6Illustration (Example 2—Gain for Debtor): Morgan National reports interest revenue the same as the previous example—TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14AILLUSTRATION 14A-7Schedule of Interest and Amortization after Debt RestructuringLO 6Illustration (Example 2—Gain for Debtor): Accounting for periodic interest payments and final principal payment.TROUBLED-DEBT RESTRUCTURINGSAPPENDIX 14AILLUSTRATION 14A-8Debtor and Creditor Entries to Record Periodic Interest and Final Principal PaymentsLO 6LO 7 Compare the accounting for long-term liabilities under GAAP and IFRS.RELEVANT FACTS - SimilaritiesAs indicated in our earlier discussions, GAAP and IFRS have similar liability definitions, and liabilities are classified as current and non-current.Much of the accounting for bonds and long-term notes is the same for GAAP and IFRS.Under GAAP and IFRS, bond issue costs are netted against the carrying amount of the bonds.RELEVANT FACTS - DifferencesUnder 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 IFRS, companies do not use premium or discount accounts but instead show the bond at its net amount.LO 7RELEVANT FACTS - DifferencesGAAP uses the term troubled-debt restructurings and has developed specific guidelines related to that category of loans. IFRS generally assumes that all restructurings will be accounted for as extinguishments of debt. IFRS requires a liability and related expense or cost be recognized when a contract is onerous. Under GAAP, losses on onerous contracts are generally not recognized under GAAP unless addressed by an industry- or transaction-specific requirements.LO 7ON THE HORIZONThe FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.LO 7Under IFRS, bond issuance costs, including the printing costs and legal fees associated with the issuance, should be:expensed in the period when the debt is issued.recorded as a reduction in the carrying value of bonds payable.accumulated in a deferred charges account and amortized over the life of the bonds.reported as an expense in the period the bonds mature or are retired.IFRS SELF-TEST QUESTIONLO 7Which of the following is stated correctly?Current liabilities follow non-current liabilities on the statement of financial position under GAAP but non-current liabilities follow current liabilities under IFRS.IFRS does not treat debt modifications as extinguishments of debt.Bond issuance costs are recorded as a reduction of the carrying value of the debt under GAAP but are recorded as an asset and amortized to expense over the term of the debt under IFRS.Under 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.IFRS SELF-TEST QUESTIONLO 7All of the following are differences between IFRS and GAAP in accounting for liabilities except:When a bond is issued at a discount, GAAP records the discount in a separate contra-liability account. IFRS records the bond net of the discount.Under IFRS, bond issuance costs reduces the carrying value of the debt. Under GAAP, these costs are recorded as an asset and amortized to expense over the terms of the bond. GAAP, but not IFRS, uses the term “troubled debt restructurings.”GAAP, but not IFRS, uses the term “provisions” for contingent liabilities which are accrued.IFRS SELF-TEST QUESTIONLO 7“Copyright © 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. 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