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Bonds PayableBonds Payable Long-Term Notes Long-Term Notes PayablePayable
Reporting and Reporting and Analyzing Analyzing Long-Term DebtLong-Term Debt
Issuing bondsIssuing bonds
Types and ratingsTypes and ratings
ValuationValuation
Effective-interest Effective-interest methodmethod
Costs of issuingCosts of issuing
ExtinguishmentExtinguishment
Notes issued at face Notes issued at face valuevalue
Notes not issued at Notes not issued at face valueface value
Special situationsSpecial situations
Mortgage notes Mortgage notes payablepayable
Presentation and Presentation and analysisanalysis
Chapter 14: Long-term liabilitiesconsists 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.
Learning Objectives:
Learning Objective :
Bonds PayableBonds Payable
Issuing bondsIssuing bonds
Types and ratingsTypes and ratings
ValuationValuation
Effective-interest methodEffective-interest method
Costs of issuingCosts of issuing
ExtinguishmentExtinguishment
Represents a promise to pay:
(1) sum of money at designated maturity date
+
(2) periodic interest at a specified rate on the maturity
amount (face value). Interest payments usually made
semiannually.
Paper certificate, typically a $1,000 or a $5,000 face
value. Price of bonds stated at 100s.
Bonds Payable= Bond indenture
The Process of Bond Issuance
Underwriters are usually investment banks
The issuing company may sell the bonds directly to a large institution without the aid of an underwriter ( private placement).The issuing company may sell the bonds directly to a large institution without the aid of an underwriter ( private placement).
Types of Bonds: On the basis of
Bond Ratings (Source: BestVest Investments, Ltd)
Moody's S & P Meaning
Aaa AAABest quality, with the smallest amount of risk. Issuers are extremely stable and dependable.
Aa AAHigh quality, with a slightly higher degree of long-term risk.
A AHigh to medium quality, with many strong attributes but with some risk exposure to changing economic conditions.
Baa BBBMedium quality, currently adequate but with significant risk possible over the long term.
Bond Ratings (contd.)Ba BB
Some speculative element, with moderate security but not well safeguarded for the long haul.
B BAble to pay now but with a significant risk of default in the future.
Caa CCC Poor quality with a clear danger of default.
Ca CC High speculative nature, often in or near default.
C CLowest rated, poor prospects of payment going forward but may be current in payments.
-- D In default.
The investment community values a bond at the present
value of its expected future cash flows, which consist of
(1) interest and (2) principal.
The investment community values a bond at the present
value of its expected future cash flows, which consist of
(1) interest and (2) principal.
Valuation of Bonds – Discount and Premium
Selling 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.
Interest Rates
Stated, coupon, or nominal rate =
The interest rate written in the terms of the bond indenture.
Market rate, discount rate, effective rate or yield rate =
rate that provides an acceptable return on an investment
commensurate with the issuer’s risk characteristics.
Rate of interest actually earned by the bondholders.
Valuation of Bonds – Discount and Premium
Interest Rates
Stated, coupon, or nominal rate =
The interest rate written in the terms of the bond indenture.
Market rate, discount rate, effective rate or yield rate =
rate that provides an acceptable return on an investment
commensurate with the issuer’s risk characteristics.
Rate of interest actually earned by the bondholders.
Valuation of Bonds – Discount and Premium
Between the time the company sets the terms and the time it issues the bonds, the market conditions and the financial position of the issuing corporation may change significantly.
Such changes affect the marketability of the bonds and thus their selling price.
Bonds Sold AtMarket Interest
6%
8%
10%
Premium
Face Value
Discount
Assume Stated Rate of 8%Assume Stated Rate of 8%
Valuation of Bonds – Discount and Premium
Discount on bonds payable is a liability valuation account,
that reduces the face amount of the related liability (contra-
account).
Classification of Discount and Premium
Balance Sheet (in thousands)
Assets
Cash 40,000$ I nventories 95,000 Plant assets, net 280,000
Total assets 415,000$
Liabilities and Equity
Accounts payable 80,000$ Bonds payable 140,000 Disount on bonds payable (15,000) Common stock, $1 par 150,000 Retained earnings 60,000
Total liabilities and equity 415,000$
Premium on bonds payable
is a liability valuation account,
that adds to the face amount of
the related liability (adjunct
account).
Valuation of Bonds – Discount and Premium
How do you calculate the amount of interest that is actually paid to the bondholder each period?
(Stated rate x Face Value of the bond)
How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds?
(Market rate x Carrying Value of the bond)
Valuation of Bonds – Discount and Premium
1- Use Market Rate of interest ( Discount rate)
2- Computation of selling price:
- PV of maturity value, plus
- PV of interest payments
3- Semi-annual interest paying bonds:
- Require doubling the periods
- Halving the interest rate
Calculating the Selling Price of a Bond
Valuation of Bonds – Discount and Premium
15
Accounting for Bonds Payable –Discount and Premium This discount or premium would be amortized over the
life of the bond.
Amortization methods:1. Straight-Line: the Discount or premium would be amortized equally over the life of the bond.
2. Effective Interest Method Interest Expense = Carrying value of Bond at the
beginning of the period effective rate
16
Accounting for Bonds Payable APB Opinion 21 requires the use of the effective
interest method for the amortization of premium or discount when two amortization methods generate significant different result.
However, the effective interest rate is usually changing from period to period during the life of a bond. As a result, the book value of bonds, very often, does
not equal the present value of bonds.
Produces a periodic interest expense
equal to a constant percentage of
the carrying value of the bonds.
Illustration 14-3
Effective-Interest Method
Valuation of Bonds
Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2014, with a stated interest rate of 8%. Interest paid annually on Dec. 31. Calculate the issue price of the bonds, market interest rate of 8%.
Principal $100,000 x 0.79383 = 79,383$ I nterest 8,000 x 2.57710 = 20,617
Present value 100,000 Face value 100,000
Discount 0$
Market Rate 8% Market Rate 8% (PV for 3 periods at 8%)(PV for 3 periods at 8%)
Solution on notes Solution on notes pagepage
Bonds Issued at Par
Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, a stated interest rate of 8%, and market rate of 8%.
Journal entries?Cash I nterest Carrying
Date Paid Expense Amount
1/ 1/ 11 100,000$
12/ 31/ 11 8,000$ 8,000$ 100,000
12/ 31/ 12 8,000 8,000 100,000
12/ 31/ 13 8,000 8,000 100,000
Bonds Issued at Par
Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 10%.
Principal $100,000 x 0.75132 = 75,132$ I nterest 8,000 x 2.48685 = 19,895
Present value 95,027 Face value 100,000
Discount (4,973)$
Market Rate 10% Market Rate 10% (PV for 3 periods at 10%)(PV for 3 periods at 10%)
Solution on notes Solution on notes pagepage
Bonds Issued at a Discount
Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, a stated interest rate of 8%, and market rate of 10%.
8% 10%Cash I nterest Discount Carrying
Date Paid Expense Amortized Amount
1/ 1/ 11 95,027$
12/ 31/ 11 8,000$ 9,503$ 1,503$ 96,530
12/ 31/ 12 8,000 9,653 1,653 98,183
12/ 31/ 13 8,000 9,817 1,817 100,000 **
* * roundingrounding
Amortize Discount via
Effective Interest method
Illustration: Stated rate = 8%. Market rate = 10%.
1/1/11 Cash 95,027
Discount on bonds payable 4,973
Bonds payable 100,000
12/31/11 Interest expense 9,503
Discount on bonds payable 1,503
Cash 8,000
Journal entries for 2011:
Amortize Discount via
Effective Interest method
Illustration: Stated rate = 8%. Market rate = 10%.
12/31/11 Interest expense 9,658
Discount on bonds payable 1,658
Cash 8,000
Total discount:
100,000-95,027= 4,973
4,973 / 3= 1,658 per period
Amortize Discount via
Straight-line method
Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 6%.
Principal $100,000 x 0.83962 = 83,962$ I nterest 8,000 x 2.67301 = 21,384
Present value 105,346 Face value 100,000
Premium 5,346$
Market Rate 6% Market Rate 6% (PV for 3 periods at 6%)(PV for 3 periods at 6%)
Solution on notes Solution on notes pagepage
Bonds Issued at a Premium
Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, a stated interest rate of 8%, and market rate of 6%.
8% 6%Cash I nterest Premium Carrying
Date Paid Expense Amortized Amount
1/ 1/ 11 105,346$
12/ 31/ 11 8,000$ 6,321$ 1,679$ 103,667
12/ 31/ 12 8,000 6,220 1,780 101,887
12/ 31/ 13 8,000 6,113 1,887 100,000
Unamortized bond issue costs are treated as a deferred charge and amortized
over the life of the debt.
Amortize Premium via
Effective Interest method
Illustration: Stated rate = 8%. Market rate = 6%.
Journal entries for 2011:
1/1/11 Cash 105,346
Premium on bonds payable 5,346
Bonds payable 100,000
12/31/11 Interest expense 6,321
Premium on bonds payable 1,679
Cash 8,000
Amortize Premium via
Effective Interest method
Total Premium: 105,346 – 100,000=5,346
5,346/3=1,782
Journal entries for 2011:
12/31/11 Interest expense 6,218
Premium on bonds payable 1,782
Cash 8,000
Amortize Premium via
Straight Line method
1/1: Interest payment date ($600)The first payment starts on 7/1 of the issuing year1/1: Interest payment date ($600)The first payment starts on 7/1 of the issuing year
7/1: Interest payment date ($600)7/1: Interest payment date ($600)
3/1: Date of Issue.Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue. ( Pay $200)
3/1: Date of Issue.Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue. ( Pay $200)
On the next semiannual interest payment date, purchasers will receive the full six months’ interest payment
On the next semiannual interest payment date, purchasers will receive the full six months’ interest payment
Bonds Issued between Interest DatesBonds Issued between Interest Dates
Consider: Prorate “Interest” and “Discount” or “Premium”.
Illustration: On March 1, 2010, KC Corporation issues 10-year
bonds, dated January 1, 2010, 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. Prepare the journal entry to
record the bond issuance at par plus accrued interest.
Cash 808,000
Bonds Payable
800,000
Bond Interest Expense
8,000
($800,000 x .06 x 2/12) = $8,000
Bonds Issued at Par between Interest Dates – ( Use the Straight-line method to count for Interest)Bonds Issued at Par between Interest Dates – ( Use the Straight-line method to count for Interest)
Illustration: On July 1, 2010, four months after the
date of purchase, KC pays the purchaser six months’ interest.
KC makes the following entry on July 1, 2010.
Bond Interest Expense 24,000
Cash
24,000($800,000 x .06 x 6/12) = $24,000 Bond Interest Expense
Debit / Dr. Credit / Cr.
$24,000 $8,000
$16,000$16,000
Bonds Issued at Par between Interest Dates – (Straight-line method)Bonds Issued at Par between Interest Dates – (Straight-line method)
Debt issued between Interest Payment Dates at a DiscountDebt issued between Interest Payment Dates at a Discount
Present value of the bond at 1/1/2015 based on yield of 10% for a term of 2 years. The stated interest rate is 8%.
The interest is paid semiannually. The Face value of the bond is $200,000. The bond was issued on March 1, 2015.
How much should be the issue price?
P.V. of the principal 200,000(given) x .8227 = 164,540
P.V. of Interest 8,000(given) x 3.5460 = 28,368
P.V. on 1/1/2015 $192,908
Debt issued between Interest Payment Dates at a Discount
6 Months Ending
Interest Expense
CashDiscount
AmortizedB.V
1/1/2015 - - - 192,908 7/1/2015 9,645* 8,000 1,645** 194,553
From the 1/1~3/1/2015:• 192,908 x 0.05 = 9,645• Prorated amortization: 9,645 - 8,000 =1,645 1,645*2/6= 548 in which $548 was for the period of 1/1 - 3/1/2015
Debt issued between Interest Payment Dates at A Discount
The P.V. of the bonds on 3/1/2015 =>
(PV0 + Discount Amortized for 2 months) =>192,908x 0.05 (9,645) – 8,000 = $1,645.
PV on 3/1/2015= $192,908 + 1,645 x 2/6= 192,908 + 548= 193,456
Accrued interest from 1/1~ 3/1/2015: = 200,000 x 4% x 2/6=2,667
Debt issued between Interest Payment Dates at A Discount
Therefore, the issue price on 3/1/2015 =>193,456 + 2,667 = $196,123 (including the 2-month accrued interest)
Cash 196,123
Dis. On B/P 6,544**
B/P 200,000
Interest Expense 2,667
** (200,000 - 193,456) or {(200,000 - 192,908) – 548}
Debt issued between Interest Payment Dates at A Discount or A Premium6 Months
EndingInterest
ExpenseCash
Discount Amortize
dB.V
1/1/2015 - - - 192,908 7/1/2015 9,645* 8,000 1,645** 194,55312/31/2015 9,728 8,000 1,728 196,281 7/1/2015 9,814 8,000 1,814 198,09512/31/2015 9,905 8,000 1,905 200,000
Debt issued between Interest Payment Dates at A Discount or A Premium7/1/2015 Interest Expense 9,097
Discount on B/P*1,097
Cash 8,000
* 1,645-548=1,097
12/31/2015 Interest Expense 9,728 Cash8,000
Discount on B/P1,728
Extinguishment before Maturity Date
Reacquisition price > Net carrying amount = Loss
Net carrying amount > Reacquisition price = Gain
At time of reacquisition, unamortized premium or discount,
and any costs of issue applicable to the bonds, must be
amortized up to the reacquisition date.
Extinguishment of Debt
Illustration: Three year 8% bonds of $100,000 issued on Jan. 1, 2011, are recalled at 105 on Dec. 31, 2012. Expenses of recall are $2,000. Market interest on issue date was 10%.
8% 10%Cash I nterest Discount Carrying
Date Paid Expense Amortized Amount
1/ 1/ 11 95,027$
12/ 31/ 11 8,000$ 9,503$ 1,503$ 96,530
12/ 31/ 12 8,000 9,653 1,653 98,183
Account Balances at Dec. 31, 2012:
Bonds payable =
$98,183
Discount on bonds payable ($4,973–1,503-1,653) =
1,817
Extinguishment of Debt
Illustration: Three year 8% bonds of $100,000 issued on Jan. 1, 2011, are recalled at 105 on Dec. 31, 2012. Expenses of recall are $2,000. Market interest on issue date was 8%.
Journal entry at Dec. 31, 2012:
Bonds payable 100,000
Loss on extinguishment 8,817
Cash 107,000
Discount on bonds payable 1,817
Reacquisition price = $105,000 + 2,000 = $107,000
Extinguishment of Debt
Unamortized bond issue costs are treated as a deferred
charge and amortized over the life of the debt.
Valuation of Bonds
Cost of Issuing Bonds
Illustration: Microchip Corporation sold $20,000,000 of 10-year
debenture bonds for $20,795,000 on January 1, 2014 (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.
Jan. 1,
2014
Cost of Issuing Bonds
Cash 20,550,000
Unamortized Bond Issue Costs 245,000
Premium on Bonds Payable 795,000
Bonds Payable 20,000,000
Illustration: Microchip Corporation sold $20,000,000 of 10-year
debenture bonds for $20,795,000 on January 1, 2014 (also the
date of the bonds). Costs of issuing the bonds were $245,000.
Dec. 1,
2014
Bond Issue Expense 24,500
Unamortized Bond Issue Costs 24,500
Illustration: On January 1, 2007, 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
Extinguishment of Debt
Extinguishment of Debt
Bonds Payable 800,000
Loss on Redemption of Bonds 32,000
Discount on Bonds Payable
14,400
Unamortized Bond Issue Costs
9,600
Cash
808,000
General Bell records the reacquisition and cancellation of the
bonds as follows:
Learning Objective :
Long-Term Notes PayableLong-Term Notes Payable
Notes issued at face valueNotes issued at face value
Notes not issued at face valueNotes not issued at face value
Special situationsSpecial situations
Mortgage notes payableMortgage notes payable
Long-Term Notes Payable
1. Notes issued at face value
2. Notes NOT issued at face value Zero-interest-bearing notes:
It measures the note’s present value by the cash received. The implicit interest rate is the rate that equals the cash received with the amounts to be paid in the future.
Interest bearing notes
BE14-13: Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company on January 1, 2011, and received cash of $47,663. The implicit interest rate is 12%. Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest.
0% 12%Cash I nterest Discount Carrying
Date Paid Expense Amortized Amount
1/ 1/ 11 47,663$
12/ 31/ 11 0 5,720$ 5,720$ 53,383
12/ 31/ 12 0 6,406 6,406 59,788
12/ 31/ 13 0 7,175 7,175 66,963
12/ 31/ 14 0 8,037 8,037 75,000
Zero-Interest-Bearing Notes
(a) Cash 47,663
Discount on notes payable 27,337
Notes payable 75,000
(b) Interest expense 5,720
Discount on notes payable 5,720($47,663 x 12%)
BE14-13: Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company on January 1, 2011, and received cash of $47,663. The implicit interest rate is 12%. Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest.
Zero-Interest-Bearing Notes
BE14-14: McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on Jan. 1, 2011, and received a computer that normally sells for $31,495. The note requires annual interest payments each Dec. 31. The market rate of interest is 12%. Prepare McCormick’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 interest.
5% 12%Cash I nterest Discount Carrying
Date Paid Expense Amortized Amount
1/1/11 31,495$
12/31/11 2,000$ 3,779$ 1,779$ 33,274
12/31/12 2,000 3,993 1,993 35,267
12/31/13 2,000 4,232 2,232 37,499
12/31/14 2,000 4,501 2,501 40,000
Interest-Bearing Notes
(a) Computer 31,495
Discount on notes payable 8,505
Notes payable40,000
(b) Interest expense 3,779
Cash2,000
Discount on notes payable 1,779
5% 12%Cash I nterest Discount Carrying
Date Paid Expense Amortized Amount
1/1/11 31,495$
12/31/11 2,000$ 3,779$ 1,779$ 33,274
12/31/12 2,000 3,993 1,993 35,267
Interest-Bearing Notes
Notes Issued for Property, Goods, and 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 market value of the debt instrument.
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 impute an interest rate.
The choice of imputed interest rate is affected by:
prevailing rates for similar instruments
factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.
Special Notes Payable Situations
The process of interest rate approximation is called “ Imputation”.The process of interest rate approximation is called “ Imputation”.
Special Notes Payable Situations
Illustration: On December 31, 2014, 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, 2019, 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.
Special Notes Payable Situations
Illustration 14-15
Illustration 14-16
Special Notes Payable Situations
Wunderlich records issuance of the note on Dec. 31, 2014, in
payment for the architectural services as follows.
Building (or Construction in Process) 418,239
Discount on notes payable 131,761
Notes Payable
550,000
Special Notes Payable Situations
Illustration 14-17
Payment of first year’s interest and amortization of the discount.
Interest Expense 33,459
Discount on Notes Payable 22,459
Cash 11,000
LO 6
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.
Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.
Presentation and Analysis of Long-Term Debt
Analysis of Long-Term Debt
Two ratios that provide information about debt-paying ability and long-run solvency are:
Total debt
Total assets
Debt to total assets
=
The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.
1.1.
Presentation and Analysis of Long-Term Debt
Analysis of Long-Term Debt
Two ratios that provide information about debt-paying ability and long-run solvency are:
Income before income taxes and interest expense
Interest expense
Times interest earned =
Indicates the company’s ability to meet interest payments as they come due.
2.2.
Presentation and Analysis of Long-Term Debt
The Fair Value Option for Bonds –SFAS No. 159
The book value is computed by “ historical effective interest rate” at date of issue.
The present value (fair value) of bonds is computed by the current effective interest rate.
SFAS 159 allows companies to have the option to report the fair value of the bond on the balance sheet.
59
The Fair Value Option – SFAS No. 159
The difference between the fair value of bonds and the book value is calculated at the end of each period .
This difference is reported as unrealized losses (i.e., fair value > book value) or unrealized gains (i.e., fair value < book value) in the
income statement.
60
SFAS 159 (contd.) Fair value option is an irrevocable decision:
This reporting method can only be adopted at the issuance (origination) of a bond (loan).
Companies can choose the fair value option for one, a few or all of their financial liabilities.
Pension and lease liabilities are excluded from the fair value option.
61
14-62
Non-current liabilities are recorded at fair value, with unrealized
holding gains or losses reported as part of net income.
Fair Value Measurement
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 20,000
Unrealized Holding Gain or Loss—Income
20,000
The Fair Value Option
Usual Progression in Troubled-Debt Situations
A troubled-debt restructuring involves one of two basic types of transactions:
1. Settlement of debt at less than its carrying amount.
2. Continuation of debt with a modification of terms.
A troubled debt restructurings 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.
A troubled debt restructurings 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.
1. Settlement of Debt1. Settlement of Debt
Can involve either a
transfer of noncash assets (real estate, receivables, or other
assets) or
the issuance of the debtor’s stock.
Creditor should account for the noncash assets or equity interest
received at their fair value.
14-65
Illustration : 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 16,000,000
Allowance for Doubtful Accounts 4,000,000
Note Receivable from Union Mortgage
20,000,000
1. Settlement of Debt (Transfer of Assets):
14-66
Illustration : 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 20,000,000
Loss on Disposal of Land 5,000,000
Land
21,000,000
Gain on Restructuring of Debt
4,000,000
1. Settlement of Debt (Transfer of Assets):
14-67
Illustration: 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.
Investment 16,000,000
Allowance for Doubtful Accounts 4,000,000
Note Receivable from Union Mortgage
20,000,000
1. Settlement of Debt (Granting an Equity Interest):
14-68
Illustration: 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
Additional Paid-in Capital
12,800,000
Gain on Restructuring of Debt
4,000,000
1. Settlement of Debt (Granting an Equity Interest):
2. Modification of Terms2. Modification of Terms
A debtor’s serious short-run cash flow problems will lead it to
request one or a combination of the following modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.
On December 31, 2013, 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:
1. Reducing the principal obligation from $10,500,000 to $9,000,000;
2. Extending the maturity date from December 31, 2013, to December 31,
2017 ( 4 more years) ; and
3. Reducing the interest rate from 12% to 8% (Stated interest rate).
No Gain for debtor:Pre-restructuring carrying value ( $10,500,000) < after restructuring of $11,880,000*
*11,880,000= $9,000,000 ( new principal) +$2,880,000 (interest: 9,000,000*8%*4)
(Example 1—No Gain for Debtor):
New effective interest rate
11,880,000-10,500,000=1,380,000
Notes Payable 356,056
Interest Expense 363,944
Cash
720,000
Dec. 31, 2014
(Example 1—No Gain for Debtor):Schedule Showing Reduction of Carrying Amount of NoteDebtor’s Calculations:
Debtor must compute a new effective interest rate ( indicates by i in the formula)
to record interest expense in the future period.
The rate necessary to discount the total future cash flows ( $11,880,000) to a present value equal to the remaining balance ($10,500,000) $10,500,000 = 1/(1+i)4 * $9,000,000 + {1-(1/(1+i) 4 )/i }*$720,000
Calculator: N=4 PV=10,500,000 PMT=-720,000 FV= -9,000,000 1/YR= 3.466 ( New effective interest)
Notes Payable 9,000,000
Cash
9,000,000
Maturity Maturity date: date:
Dec. 31, Dec. 31, 20172017
(Example 1—No Gain for Debtor): Debtor’s Computation
Morgan National Bank (creditor)
Morgan National Bank records bad debt expense as follows
Bad Debt Expense 2,593,428
Allowance for Doubtful Accounts 2,593,428
Market Interest rate: 12%
(Example 1—No Gain for Debtor): Creditor’s Computation
Creditor Calculations
Illustration 14A-4Illustration 14A-4
In subsequent periods, Morgan National Bank reports interest
revenue based on the historical effective rate.
Cash 720,000
Allowance for Doubtful Accounts 228,789
Interest Revenue 948,789
Dec. 31, 2010Dec. 31, 2010
b. 7,906,572*12%=948,789c. 948,789-720,000=228,789d. 28 adjustment to compensate for rounding
(Example 1—No Gain for Debtor): Creditor’s Computation
Creditor Calculations
The 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 9,000,000
Allowance for Doubtful Accounts 1,500,000
Notes receivable 10,500,000
Dec. 10, 2017Dec. 10, 2017
(Example 1—No Gain for Debtor): Creditor’s Computation
Illustration: 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, 2017 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) < $10,500,000 ( difference is $1,260,000)
Under these circumstances, Resorts Development (debtor) reduces the carrying
amount of its payable $1,260,000 and records a gain of $1,260,000.
(Example 2—Gain for Debtor):
Note Payable carrying value after restructuring: 10,500,000-1,260,000=9,240,000 ( Equal the sum of the undiscounted cash flows) ---Imputed interest rate is 0 %.
Debtor AccountingDebtor Accounting
Morgan National Bank (creditor) debits its Bad Debt Expense for $4,350,444.
(Example 2—Gain for Debtor):
Creditor AccountingCreditor Accounting
Creditor Calculations
Morgan National reports interest revenue the same as the previous
example—
(Example 2— Gain for Debtor):
Accounting for periodic interest payments and final principal payment.
(Example 2— Gain for Debtor):
Recognize no interest expense 7,000,000*8%
Recommended