Valuation of Bonds Payable

Assume Stated Rate of 8% Market Interest Bonds Sold At

6% 8% 10%
14-1

Premium Par Value Discount

LO 3

Valuation of Bonds
Bonds Issued between Interest Dates
Bond investors 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, bond investors will receive the full six months interest payment.

14-2

LO 3 Describe the accounting valuation for bonds at date of issuance.

Bonds Issued between Interest Dates

Illustration: on March 1, 2012, Taft Corporation issues 10year bonds, dated January 1, 2012, 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.
Cash Bonds payable Interest expense
($800,000 x .06 x 2/12)

808,000 800,000 8,000

14-3

LO 4 Apply the methods of bond discount and premium amortization.

Bonds Issued between Interest Dates

On July 1, 2012, four months after the date of purchase, Taft pays the purchaser six months interest, by making the following entry. Interest expense Cash 24,000 24,000

14-4

LO 4 Apply the methods of bond discount and premium amortization.

Bonds Issued between Interest Dates

If, however, Taft issued the 6 percent bonds at 102, its March 1 entry would be: Cash Bonds Payable Premium on Bonds Payable ($800,000 x .02) Interest Expense
* [($800,000 x 1.02) + ($800,000 x .06 x 2/12)]

824,000

800,000 16,000 8,000

14-5

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds.
Illustration 14-3

14-6

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Bonds Issued at a Discount
Illustration: Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2012, due on January 1, 2017, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 10%. Calculate the bond proceeds.
Illustration 14-4

14-7

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Illustration 14-5

14-8

LO 4

EffectiveEffective-Interest Method
Illustration 14-5

Journal entry on date of issue, Jan. 1, 2012. Cash Discount on bonds payable Bonds payable 92,278 7,722 100,000

14-9

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Illustration 14-5

Journal entry to record first payment and amortization of the discount on July 1, 2012. Interest expense Discount on bonds payable Cash
14-10

4,614 614 4,000

LO 4

EffectiveEffective-Interest Method
Illustration 14-5

Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2012. Interest expense Interest payable Discount on bonds payable
14-11

4,645 4,000 645

LO 4

EffectiveEffective-Interest Method
Bonds Issued at a Premium
Illustration: Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2012, due on January 1, 2017, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 6%. Calculate the bond proceeds.
Illustration 14-6

14-12

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Illustration 14-7

14-13

LO 4

EffectiveEffective-Interest Method
Illustration 14-7

Journal entry on date of issue, Jan. 1, 2012. Cash Premium on bonds payable Bonds payable 108,530 8,530 100,000

14-14

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Illustration 14-7

Journal entry to record first payment and amortization of the premium on July 1, 2012. Interest expense Premium on bonds payable Cash
14-15

3,256 744 4,000

LO 4

EffectiveEffective-Interest Method
Accrued Interest
What happens if Evermaster prepares financial statements at the end of February 2012? In this case, the company prorates the premium by the appropriate number of months to arrive at the proper interest expense, as follows.
Illustration 14-8

14-16

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Accrued Interest
Illustration 14-8

Evermaster records this accrual as follows. Interest expense Premium on bonds payable Interest payable
14-17

1,085.33 248.00 1,333.33

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Classification of Discount and Premium
Companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond.

14-18

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Cost of Issuing Bonds
Unamortized bond issue costs are treated as a deferred charge and amortized over the life of the debt. Illustration: Microchip Corporation sold $20,000,000 of 10year debenture bonds for $20,795,000 on January 1, 2012 (also the date of the bonds). Costs of issuing the bonds were $245,000. Microchip records the issuance of the bonds and amortization of the bond issue costs as follows.

14-19

LO 4 Apply the methods of bond discount and premium amortization.

EffectiveEffective-Interest Method
Illustration: Microchip Corporation sold $20,000,000 of 10-year debenture bonds for $20,795,000 on January 1, 2012 (also the date of the bonds). Costs of issuing the bonds were $245,000. Jan. 1, 2012 Cash Unamortized bond issue costs Premium on bonds payable Bonds payable Dec. 1, 2012
14-20

20,550,000 245,000 795,000 20,000,000 24,500 24,500

Bond issue expense Unamortized bond issue costs

LO 4 Apply the methods of bond discount and premium amortization.

Extinguishment of Debt
Illustration: On January 1, 2005, General Bell Corp. issued at 97 bonds with a par value of $800,000, due in 20 years. It incurred bond issue costs totaling $16,000. Eight years after the issue date, General Bell calls the entire issue at 101 and cancels it. General Bell computes the loss on redemption (extinguishment).
Illustration 14-10

14-21

LO 5 Describe the accounting for the extinguishment of debt.

Extinguishment of Debt
General Bell records the reacquisition and cancellation of the bonds as follows: Bonds payable Loss on redemption of bonds Discount on bonds payable Unamortized bond issue costs Cash 800,000 32,000 14,400 9,600 808,000

14-22

LO 5 Describe the accounting for the extinguishment of debt.

LongLong-Term Notes Payable

Accounting is Similar to Bonds


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.

14-23

LO 6 Explain the accounting for long-term notes payable.

Notes Issued at Face Value

BE14-12: Coldwell, Inc. issued a $100,000, 4-year, 10% note at face value to Flint Hills Bank on January 1, 2013, and received $100,000 cash. The note requires annual interest payments each December 31. Prepare Coldwells journal entries to record (a) the issuance of the note and (b) the December 31 interest payment. (a) Cash Notes payable (b) Interest expense Cash
($100,000 x 10% = $10,000)
LO 6 Explain the accounting for long-term notes payable.

100,000 100,000 10,000 10,000

14-24

Notes Not Issued at Face Value

Zero-Interest-Bearing Notes
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.

14-25

LO 6 Explain the accounting for long-term notes payable.

Zero-InterestZero-Interest-Bearing Notes
BE14-13: Samson Corporation issued a 4-year, $75,000, zerointerest-bearing note to Brown Company on January 1, 2013, and received cash of $47,663. The implicit interest rate is 12%. Prepare Samsons journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest.
0% Cash Paid 0 0 0 0 12% Interest Expense $ 5,720 6,406 7,175 8,037

Date 1/1/13 12/31/13 12/31/14 12/31/14 12/31/15

14-26

Discount Amortized $ 5,720 6,406 7,175 8,037

Carrying Amount $ 47,663 53,383 59,788 66,963 75,000

LO 6

Zero-InterestZero-Interest-Bearing Notes
BE14-13: Samson Corporation issued a 4-year, $75,000, zerointerest-bearing note to Brown Company on January 1, 2013, and received cash of $47,663. The implicit interest rate is 12%. Prepare Samsons journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest.
(a) Cash Discount on Notes Payable Notes Payable (b) Interest expense Discount on Notes Payable
14-27

47,664 27,336 75,000 5,720 5,720

LO 6 Explain the accounting for long-term notes payable.

InterestInterest-Bearing Notes
BE14-14: McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on Jan. 1, 2013, and received a computer that normally sells for $31,495. The note requires annual interest payments each Dec. 31. The market rate of interest is 12%. Prepare McCormicks journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 interest.
5% Cash Paid $ 2,000 2,000 2,000 2,000 12% Interest Discount Expense Amortized $ 3,779 3,993 4,232 4,501 $ 1,779 1,993 2,232 2,501 Carrying Amount $ 31,495 33,274 35,267 37,499 40,000
LO 6

Date 1/1/13 12/31/13 12/31/14 12/31/15 12/31/16

14-28

InterestInterest-Bearing Notes
5% Cash Paid $ 2,000 2,000 12% Interest Discount Expense Amortized $ 3,779 3,993 $ 1,779 1,993 Carrying Amount $ 31,495 33,274 35,267

Date 1/1/11 12/31/11 12/31/12

(a) Computer Discount on notes payable Notes payable (b) Interest expense Cash
14-29

31,495 8,505 40,000 3,779 2,000 1,779

Discount on notes payable

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.

14-30

LO 6 Explain the accounting for long-term notes payable.

Special Notes Payable Situations

Choice of Interest Rates
If a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, the company must approximate an applicable interest rate. Choice of rate is affected by: Prevailing rates for similar instruments. Factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.

14-31

LO 6 Explain the accounting for long-term notes payable.

Special Notes Payable Situations

Illustration: On December 31, 2012, 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, 2017, 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 Wunderlichs credit rating, the absence of collateral, the prime interest rate at that date, and the prevailing interest on Wunderlichs other outstanding debt, the company imputes an 8 percent interest rate as appropriate in this circumstance.

14-32

LO 6 Explain the accounting for long-term notes payable.

Special Notes Payable Situations

Illustration 14-15

Illustration 14-16

14-33

LO 6 Explain the accounting for long-term notes payable.

Special Notes Payable Situations

Wunderlich records issuance of the note on Dec. 31, 2012, in payment for the architectural services as follows. Building (or Construction in Process) Discount on notes payable Notes Payable 418,239 131,761 550,000

14-34

LO 6 Explain the accounting for long-term notes payable.

Special Notes Payable Situations

Illustration 14-20

Payment of first years interest and amortization of the discount. Interest expense Discount on notes payable Cash
14-35

33,459 22,459 11,000

LO 6 Explain the accounting for long-term notes payable.

Mortgage Notes Payable

A promissory note secured by a document called a mortgage that pledges title to property as security for the loan.
   

Most common form of long-term notes payable. Payable in full at maturity or in installments. Fixed-rate mortgage. Variable-rate mortgages.

14-36

LO 6 Explain the accounting for long-term notes payable.

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. The FASB believes that fair value measurement for financial instruments, including financial liabilities, provides more relevant and understandable information than amortized cost.

14-37

LO 7 Describe the accounting for the fair value option.

Fair Value Option

Fair Value Measurement
Non-current liabilities are recorded at fair value, with unrealized holding gains or losses reported as part of net income. Illustrations: Edmonds Company has issued $500,000 of 6 percent bonds at face value on May 1, 2012. Edmonds chooses the fair value option for these bonds. At December 31, 2012, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent. Bonds Payable Unrealized Holding Gain or LossIncome
14-38

20,000 20,000

LO 7 Describe the accounting for the fair value option.

Off-BalanceOff-Balance-Sheet Financing
Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations. Different Forms:
Non-Consolidated Subsidiary Special Purpose Entity (SPE) Operating Leases

14-39

LO 8 Explain the reporting of off-balance-sheet financing arrangements.

Presentation and Analysis

Presentation of Long-Term Debt
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. Fair value of the debt should be discloses. Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

14-40

LO 9 Indicate how to present and analyze long-term debt.

RELEVANT FACTS


Under 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. For example, if a $100,000 bond was issued at 97, under IFRS a company would record: Cash Bonds Payable 97,000 97,000

14-41

RELEVANT FACTS


Under GAAP, bond issue costs are recorded as an asset. Under IFRS, bond issue costs are netted against the carrying amount of the bonds. GAAP 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.

14-42