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CHAPTER 14
Long-Term Liabilities
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Long-term liability; classification; definitions.
- Issuance of bonds; types of bonds.
- Premium and discount; amortization schedules.
- Retirement and refunding of debt.
- Imputation of interest on notes.
- Fair value option. 19, 20 14 19
- Disclosures of long-term obligations.
*8. Troubled debt restructuring.
*This material is discussed in the Appendix to the Chapter.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions Brief Exercises Exercises Problems
Concepts for Analysis
- Describe the nature of bonds and indicate the accounting for bond issuances.
CA14-1,
CA14-
CA14-
CA14-
- Describe the accounting for the extinguishment of debt.
CA14-
CA14-
- Explain the accounting for long- term notes payable.
- Describe the accounting for the fair value option.
- Indicate how to present and analyze long-term debt.
15 20 4, 10 CA14-
*6. Describe the accounting for a debt restructuring.
ASSIGNMENT CHARACTERISTICS TABLE (Continued)
Item Description
Level of Difficulty
Time (minutes)
*P14-12 Debtor/creditor entries for continuation of troubled debt. Moderate 15– *P14-13 Restructure of note under different circumstances. Moderate 30– *P14-14 Debtor/creditor entries for continuation of troubled debt with new effective interest.
Complex 40–
CA14-1 Bond theory: balance sheet presentations, interest rate, premium.
Moderate 25–
CA14-2 Bond theory: price, presentation, and redemption. Moderate 15– CA14-3 Bond theory: amortization and gain or loss recognition. Simple 20– CA14-4 Off-balance-sheet financing. Moderate 20– CA14-5 Bond issue, ethics. Moderate 23–
ANSWERS TO QUESTIONS
- (a) Funds might be obtained through long-term debt from the issuance of bonds, and from the signing of long-term notes and mortgages.
(b) A bond indenture is a contractual agreement (signed by the issuer of bonds) between the bond issuer and the bondholders. The bond indenture contains covenants or restrictions for the protection of the bondholders.
(c) A mortgage is a document which describes the security for a loan, indicates the conditions under which the mortgage becomes effective (that is, conditions of default), and describes the rights of the mortgagee under default relative to the security. The mortgage accom- panies a formal promissory note and becomes effective only upon default of the note.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- If the entire bond matures on a single date, the bonds are referred to as term bonds. Mortgage bonds are secured by real estate. Debenture bonds are unsecured. The interest payments for income bonds depend on the existence of operating income in the issuing company. Callable bonds may be called and retired by the issuer prior to maturity. Registered bonds are issued in the name of the owner and require surrender of the certificate and issuance of a new certificate to complete the sale. A bearer or coupon bond is not recorded in the name of the owner and may be transferred from one investor to another by mere delivery. Convertible bonds can be converted into other securities of the issuing corporation for a specified time after issuance. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity. Deep- discount bonds (also called zero-interest bonds) are sold at a discount which provides the buyer’s total interest payoff at maturity.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) Yield rate—the rate of interest actually earned by the bondholders; it is synonymous with the effective and market rates.
(b) Nominal rate—the rate set by the party issuing the bonds and expressed as a percentage of the par value; it is synonymous with the stated rate.
(c) Stated rate—synonymous with nominal rate.
(d) Market rate—synonymous with yield rate and effective rate.
(e) Effective rate—synonymous with market rate and yield rate.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) Maturity value—the face value of the bonds; the amount which is payable upon maturity.
(b) Face value—synonymous with par value and maturity value.
(c) Market (fair) value—the amount realizable upon sale.
(d) Par value—synonymous with maturity and face value.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued)
- It is sometimes desirable to reduce bond indebtedness in order to take advantage of lower prevailing interest rates. Also the company may not want to make a very large cash outlay all at once when the bonds mature.
Bond indebtedness may be reduced by either issuing bonds callable after a certain date and then calling some or all of them, or by purchasing bonds on the open market and then retiring them.
When a portion of bonds outstanding is going to be retired, it is necessary for the accountant to make sure any corresponding discount or premium is properly amortized. When the bonds are extinguished, any gain or loss should be reported in income.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Gains or losses from extinguishment of debt should be aggregated and reported in income.
For extinguishment of debt transactions disclosure is required of the following items: (1) A description of the transactions, including the sources of any funds used to extinguish debt if it is practicable to identify the sources. (2) The income tax effect in the period of extinguishment. (3) The per share amount of the aggregate gain or loss net of related tax effect.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The entire arrangement must be evaluated and an appropriate interest rate imputed. This is done by (1) determining the fair value of the property, goods, or services exchanged or (2) determining the fair value of the note, whichever is more clearly determinable.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- If a note is issued for cash, the present value is assumed to be the cash proceeds. If a note is issued for noncash consideration, the present value of the note should be measured by the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note (whichever is more clearly determinable).
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- When a debt instrument is exchanged in a bargained transaction entered into at arm’s-length, 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 stated face amount of the debt instrument is materially different from the current sales price for the same or similar items or from the current market value of the debt instrument.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Imputed interest is the interest factor (a rate or amount) assumed or assigned which is different from the stated interest factor. It is necessary to impute an interest rate when the stated interest rate is presumed to be unreasonable. The imputed interest rate is used to establish the present value of the debt instrument by discounting, at that imputed rate, all future payments on the debt instrument. In imputing interest, the objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity. In order to accomplish that objective, consideration must be given to (1) the credit standing of the issuer, (2) restrictive covenants, (3) collateral, (4) payment and other items pertaining to the debt, (5) the existing prime interest rate, and (6) the prevailing rates for similar instruments of issuers with similar credit ratings.
LO: 3, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued)
- A fixed-rate mortgage is a note that requires payment of interest by the mortgagor at a rate that does not change during the life of the note. A variable-rate mortgage is a note that features an interest rate that fluctuates with the market rate; the variable rate generally is adjusted periodically as specified in the terms of the note and is usually limited in the amount of each change in the rate up or down and in the total change that can be made in the rate.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The fair value option is an accounting option where the company can elect to record fair values in their accounts for most financial assets and liabilities, including bonds and notes payable.
With bonds at fair value, we assume that the decline in value of the bonds is due to an interest rate increase. If not related to changes in credit risks, these gains and losses are recorded in income. In other situations, the decline may occur because the issuer become more likely to default on the bonds. That is, if the creditworthiness of the issuer declines, the value of its debt also declines. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. Thus, changes in the fair value of bonds payable for a decline in creditworthiness are included as part of other comprehensive income.
LO: 4, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) Unrealized Holding Gain or Loss—Income ................................... 2, Notes Payable........................................................................... 2,
(b) Unrealized Holding Gain or Loss—Equily ..................................... 2, Notes Payable........................................................................... 2,
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The required disclosures at the balance sheet date are future payments for sinking fund requirements and the maturity amounts of long-term debt during each of the next five years.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded. Reasons for off-balance sheet financing are: (1) Many believe removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. (2) Loan covenants are less likely to be violated. (3) The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Forms of off-balance-sheet financing include (1) investments in non-consolidated subsidiaries for which the parent is liable for the subsidiary debt; (2) use of special purpose entities (SPEs), which are used to borrow money for special projects (resulting in take-or-pay contracts); (3) operating leases, which when structured carefully give the company the benefits of ownership without reporting the liability for the lease payments.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Under GAAP, a parent company does not have to consolidate a subsidiary company that is less than 50 percent owned. In such cases, the parent therefore does not report the assets and liabilities of the subsidiary. All the parent reports on its balance sheet is the investment in the subsidiary. As a result, users of the financial statements may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued)
*30. A transaction would be recorded as a troubled debt restructuring by only the debtor if the amount for which the liability is settled is less than its carrying amount on the debtor’s books, but equal to or greater than the carrying amount on the creditor’s books. In addition to the situation created by the use of discounted versus undiscounted cash flows by creditors and debtors, this situation can occur when a debtor or creditor has been substituted for one of the parties to the original transaction.
LO: 6, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 14-
Present value of the principal
$500,000 X .37689 ......................................................... $188,
Present value of the interest payments
$22,500* X 12.46221...................................................... 280,
Issue price .............................................................. $468,
*($500,000 X 9% X 6/12)
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 14-
(a) Cash 100,
Bonds Payable 500,
(b) Interest Expense 10,
Cash ($300,000 X 10% X 6/12) ..................... 15,
(c) Interest Expense ................................................... 15,
Interest Payable ........................................... 15,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 14-
(a) Cash ($300,000 X 98%) ......................................... 294,
Discount on Bonds Payable 1,
Bonds Payable ............................................. 300,
(b) Interest Expense 5,
Premium on Bonds Payable 15,
($6,000 X 1/10) ........................................... 600
Cash ($300,000 X 10% X 6/12) ..................... 15,
(c) Interest Expense ................................................... 15,
Discount on Notes Payable 27,
($6,000 X 1/10 = $600) ............................... 600
Interest Payable ........................................... 15,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 14-6 (Continued)
(c) Interest Expense ($560,593* X 8% X 6/12) ........... 22,
Interest Payable ........................................... 21,
Discount on Bonds Payable ....................... 1,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 14-
(a) Cash 47,
Bonds Payable ............................................. 600,
Premium on Bonds Payable ....................... 44,
(b) Interest Expense ($644,636 X 6% X 6/12) ............ 19,
Premium on Bonds Payable................................. 1,
Cash ($600,000 X 7% X 6/12) ....................... 21,
(c) Interest Expense ($642,975* X 6% X 6/12) ........... 19,
Premium on Bonds Payable................................. 1,
Interest Payable ........................................... 21,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 14-
Interest Expense ($644,636 X 6% X 2/12) ....................... 6,
Premium on Bonds Payable ........................................... 554
Interest Payable ($600,000 X 7% X 2/12) ............... 7,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- BRIEF EXERCISE 14-
- (a) Cash ($300,000 X 103%) 309, - Bonds Payable 300, - Premium on Bonds Payable 9,
- (b) Interest Expense 14, - ($9,000 X 1/10 = $900) - Cash ($300,000 X 10% X 6/12) 15,
- (c) Interest Expense 14, - ($9,000 X 1/10) Premium on Bonds Payable - Interest Payable 15,
- BRIEF EXERCISE 14- LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- (a) Cash 408, - Bonds Payable 400, - Interest Expense ($400,000 X 6% X 4/12) 8,
- (b) Interest Expense 12, - Cash ($400,000 X 6% X 6/12) 12,
- (c) Interest Expense 12, - Interest Payable 12,
- BRIEF EXERCISE 14- LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- (a) Cash 559,
- Discount on Bonds Payable 40, - Bonds Payable 600,
- (b) Interest Expense ($559,224 X 8% X 6/12).................. 22, - Cash ($600,000 X 7% X 6/12) 21, - Discount on Bonds Payable 1,
- Bonds Payable 500,
- Premium on Bonds Payable 15, - Gain on Redemption of Bonds 20, - Cash 495,
- BRIEF EXERCISE 14-
- (a) Cash 100, - Notes Payable 100,
- (b) Interest Expense 10, - Cash ($100,000 X 10%) 10,
- BRIEF EXERCISE 14- LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- (a) Cash 47, - Discount on Notes Payable 27, - Notes Payable 75,
- (b) Interest Expense 5, - Discount on Notes Payable ($47,664 X 12%) 5,
SOLUTIONS TO EXERCISES
EXERCISE 14-1 (15–20 minutes)
(a) Valuation account relating to the long-term liability, bonds payable
(sometimes referred to as an adjunct account). The $3,000 would
continue to be reported as long-term.
(b) Current liability if current assets are used to satisfy the debt.
(c) Current liability, $200,000; long-term liability, $800,000.
(d) Current liability.
(e) Probably noncurrent, although if operating cycle is greater than one
year and current assets are used, this item would be classified as
current.
(f) Current liability.
(g) Current liability unless (a) a fund for liquidation has been accumu-
lated which is not classified as a current asset or (b) arrangements
have been made for refinancing.
(h) Current liability.
(i) Current liability.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 14-2 (15–20 minutes)
(a) Discount on bonds payable—Contra account to bonds payable on
balance sheet.
(b) Interest expense (credit balance)—Reclassify to interest payable on
balance sheet.
(c) Unamortized bond issue costs—Classified as part of long-term
liabilities on balance sheet.
(d) Gain on repurchase of debt—Classify as part of other gains and
losses on the income statement.
(e) Mortgage payable—Classify one-third as current liability and the
remainder as long-term liability on balance sheet.
EXERCISE 14-2 (Continued)
(f) Debenture bonds—Classify as long-term liability on balance sheet.
(g) Notes payable—Classify as long-term liability on balance sheet.
(h) Premium on bonds payable—Classify as adjunct account to Bonds
payable on balance sheet.
(i) Bonds payable—Classify as long-term liability on balance sheet.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 14-3 (15–20 minutes)
1. Simon Company:
(a) Cash .................................................... 200,
Bonds Payable .......................... 200,
(b) Interest Expense ................................ 4,
($200,000 X 9% X 3/12)
Cash ........................................... 4,
(c) Interest Expense ................................ 4,
Interest Payable ........................ 4,
2. Garfunkel Company:
(a) Cash .................................................... 105,
Bonds Payable .......................... 100,
Interest Expense ....................... 5,
($100,000 X 12% X 5/12)
EXERCISE 14-5 (15–20 minutes)
(a) Cash ($600,000 X 102%) ........................... 612,
Bonds Payable ................................. 600,
Premium on Bonds Payable ............ 12,
(b) Interest Expense ....................................... 29,
($612,000 X 9.7705% X 1/2)
Premium on Bonds Payable ..................... 102
Cash .................................................. 30,
($600,000 X 10% X 6/12)
(c) Interest Expense ..................................... 29,
($611,898 X 9.7705% X 1/2)
Premium on Bonds Payable ................... 107
Interest Payable ............................. 30,
Carrying amount of bonds at July 1, 2017:
Carrying amount of bonds at January 1, 2017 $612,
Amortization of bond premium
Carrying amount of bonds at July 1, 2017 $611,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 14-6 (15–20 minutes)
Schedule of Discount Amortization
Straight-Line Method
Year
Cash Paid Interest
Expense
Discount
Amortized
Carrying
Amount of
Bonds
Jan. 1, 2017 $1,855,816.
Dec. 31, 2017 $200,000** $228,836.80 $28,836.80** 1,884,652.
Dec. 31, 2018 200,000 228,836.80 28,836.80 1,913,489.
Dec. 31, 2019 200,000 228,836.80 28,836.80 1,942,326.
Dec. 31, 2020 200,000 228,836.80 28,836.80 1,971,163.
Dec. 31, 2021 200,000 228,836.80 28,836.80 2,000,000.
**$2,000,000 X 10%
**$28,836.80 = ($2,000,000 – $1,855,816) ÷ 5.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 14-7 (15–20 minutes)
The effective-interest or yield rate is 12%. It is determined through trial and
error using Table 6-2 for the discounted value of the principal ($1,134,860)
and Table 6-4 for the discounted value of the interest ($720,956); $1,134,
plus $720,956 equals the proceeds of $1,855,816. (A financial calculator
may be used to determine the rate of 12%.)
