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Chapter 1: Accounting for Financial Liabilities
Objectives
1. To describe long-term liabilities and describe how they are valued
2. To identify the nature and types of long-term liabilities-bond
3. To explain the methods of bond discount and premium amortization
4. To prepare the related journal entries 5. To describe the accounting treatment other
long term liabilities
Long-Term Debt
Consists of present obligations not payable within the operating cycle of the business, or a year whichever is longer.
Long-term creditors have no vote in management affairs and only receive a stated rate of interest regardless of the level of earnings.
Covenants or restrictions, for the protection of both lenders and borrowers, are stated in the bond indenture or note agreement.
Bonds Payable
Arises from a contract known as a bond indenture. Represents a promise to pay the principle at maturity and periodic interest based on the stated interest rate and the face value of the bond
the different types of bonds such as term bonds, serial bonds, secured and unsecured bonds, convertible bonds, commodity-backed bonds, deep discount bonds, registered, and coupon bonds.
Exercise 5.1: Issuance of Bonds Ghostbusters Corporation issues
RM300,000 of 9% bonds, due in 10 years, with interest payable semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds.
Solution for Exercise 5.1 n = 10 x 2 i = 10%/2
PV of the principal:300,000 x 0.37689 113,067PVOA of interest payable:[(9% x 300,000)/2] x 12.46221 168,240Price of bond 281,307
Valuation of Bonds Payable
The price of a bond is determined by the interaction between the bond's stated interest rate and its market rate. a) A bond's price is equal to the sum of the present
value of the principle and the present value of the periodic interest.
b) If the stated rate = the market rate, the bond will sell at par.
c) If the stated rate < the market rate, the bond will sell at a discount.
d) If the stated rate > the market rate, the bond will sell at a premium.
Accounting for the Issuance of Bonds
1. The face value of the bond is always reflected in the bond payable account.
2. When a bond sells at a discount, the difference between the sales price and the face value is debited to Discount on Bonds Payable. This is a contra-account to Bonds
Payable.
Accounting for the Issuance of Bonds (cont.)
3. When a bond sells at a premium, the difference between the sales price and the face value is credited to Premium on Bonds Payable. This is an adjunct account to Bonds Payable.
4. Bonds sold between interest dates.i. The price includes the interest accrued since the
last interest payment.ii. The accrued interest is credited to Bond Interest
Expense.
Exercise 5.2: Bonds Payable
The Goofy Company issued RM200,000 of 8% bonds on 1 Jan 2000. The bonds are due on 1 Jan 2005, with interest payable each 1 July and 1 Jan. Compute the issue price at
a) 100b) 97c) 105
Prepare journal entries for both investee and investor
Solution for Exercise 5.2
at 100 at 97 at 105Investee: (‘000)
Dt Cash 200
Kt Bonds Payable 200
Investee: (‘000)
Dt Cash 194
Dt Disc. bonds 6
Kt Bonds Payable 200
Investee: (‘000)
Dt Cash 210
Kt Bonds Payable 200
Kt Premium Bonds 10
Investor:
Dt Investment 200
Kt Cash 200
Investor:
Dt Investment 194
Kt Cash 194
Investor:
Dt Investment 210
Kt Cash 210
Amortization of bond discounts and premiums Two methods:
1. Effective interest method is the preferred procedure used to calculate periodic
interest expense. The carrying amount of the bonds at the start of the period is multiplied by the effective interest rate to determine the interest expense.
2. Straight-line method may be used if the results are not materially different
from those produced by the effective interest method.
Effective interest method Carrying Value of Bonds = Face Value Plus Premium (or Less
Discount). Interest Payable = Stated Interest Rate <> Face Value of Bonds. Interest Expense = Effective Interest Rate <> Carrying Value of
Bonds. If a premium exists:
Dr Interest Expense XXDr Premium on Bonds Payable XX Cr Interest Payable XX
If a discount exists:Dr Interest Expense XX
Cr Discount on Bonds Payable XXCr Interest Payable XX
Exercise 5.3: Amortization of Bonds PayableDonald Duck Company issued RM600,000 of 10%, 20-year bonds on 1 Jan 2002, at 102. Interest is payable semiannually on 1 July and 1 Jan. Donald Duck Company uses straight-line method of amortization for bond premium/discount.Prepare the journal entries to record:
a)The issuance of the bondsb)The payment of interest on 1 Julyc)The accrual of interest on 31 Dec
Solution for Exercise 5.3
a) Issuance of bonds
Dr Cash (600,000 x 1.02) 612,000
Cr Bonds Payable 600,000
Cr Premium on bond 12,000
b) Payment of interest on July 1
Dr Interest expense 29,700
Dr Premium on bond p/able 300
Cr Cash 30,000
Solution for Exercise 5.3 (cont.)
c) Accrual interest on 31 Dec
Dr Interest expense 29,700
Dr Premium on bond p/able 300
Cr. Account payable 30,000
1 Jan 2003
Dr
Cr.
Exercise 5.4: Amortization of Bonds PayableMickey Mouse Company issued RM600,000 of 10%, 10-year bonds on 1 Jan 2002. Interest is payable semiannually on 1 July and 1 Jan. Mickey Mouse Company uses effective interest method of amortization for bond premium/discount. Assume an effective rate yield of 11.5%Prepare the journal entries to record:
a)The issuance of the bondsb)The payment of interest on 1 Julyc)The accrual of interest on 31 Dec
Solution for Exercise 5.4
a) Mickey Mouse (Issuance of bonds)i=11.5/2, n=10x2
PV 600,000 x 0.10685 = 64,110PVOA 30,000 x 15.5330 = 465,990Price on 1 Jan = 530,100
Dr Cash 530,100Dr Discount on bond 69,900
Cr Bonds payable 600,000
Solution for Exercise 5.4 (cont.)
Cash Interest exp.
Amort. Disc
Balance of Bonds
530,1001 30,000 30,481* 481** 530,581***2 30,000 30,508 508 531,0893 30,000 30538 538 531,627
* 11.5% x 530,100 x 6/12 = 30,481
** 30,481 – 30,000 = 481
*** 530,100 + 481 = 530,581
Solution for Exercise 5.4 (cont.)
b) Interest expense on 1 July
Dr Interest expense 30,481
Cr discount on bond 481
Cr. Cash 30,000
b) Interest expense on 1 Jan
Dr Interest expense 30,508
Cr discount on bond 508
Cr. Interest payable 30,000
Cost of Bonds Issue
The issue of bonds involve numerous costs: Legal and accounting expense, administrative
expense (printing doc/prospectus), underwriting fees.
These costs do NOT represent an asset Methods of recognition:
1. As an expense – charge to income statement immediately
2. As a liability – debited to a deferred charge account
Exercise 5.5:Cost of Bond Issue Assume that Cyber Bhd issued a RM40,000,000
five-year bond at its par value on 1 January 1999. The bond carries a coupon interest of 10% and interest is payable on 31 Dec each year. Costs of issuing the bond, which included underwriting fees, totaled RM1,000,000. The costs were capitalized as a deferred charge and amortized on the straight line method. Show the entries to (a) record the issue of bond on 1 Jan 1999(b) recognize the amortization of the bond issue
cost and interest expense
Solution for Exercise 5.5a) Journal entry to record the issuance of the bond
Dt Cash 39,000,000
Dt Deferred bond 1,000,000
Kt Bonds Payable40,000,000
b) Journal entry to recognize amortization of deferred charge
Dt Amortization expense 200,000
Kt Deferred bond 200,000
c) Journal entry to recognize interest expense
Dt Interest expense 4,000,000
Kt Cash 4,000,000
ISSUE OF BONDS IN BETWEEN OF TWO INTEREST DATES Adjustment for accrued interest should be
done. Accrued interest is calculated for the period in
between of the date of previous interest payment with date of bond is sold.
Cash paid by buyer is the price of the bonds together with the accrued interest.
Price of bonds is the present value of the bond at the date of selling/buying.
Exercise 5.6
Date of bond June 30, 1999
Maturity date June 30, 2004
Date of selling the bond Sept 1, 1999
Date of interest payment Dec 31 and June 30
Stated interest rate 9%
Face value of bond RM200,000
Cumi Bhd purchased bond from Ciki Bhd. The following is the information on the bond.
Prepare journal entries on 1 Sept and 31 Dec
Solution for Exercise 5.6
Issued at parEffective interest rate = 9%Price of bondFace value [PV4.5%, 10 200,000 = 0.64393 x 200,000] 128,786Interest [PVOA4.5%, 10 9,000 = 7.91272 x 9,000] 71,214 Present Value 200,000(+) Increment of bond’s value from 30/6 – 1/9 [200,000 x 9% x 2/12] 3,000Cash 203,000(-) Cash paid for interest from 30/6 – 1/9 [200,000 x 9% x 2/12] (3,000)PRICE OF BOND AT 1/9/99 200,000
Solution for Exercise 5.6 (cont.) Journal entries
Sept 1Dr Cash 203,0001
Cr Interest Payable 3,0002
Bonds Payable 200,000
1. 200,000 + 3,000 (interest)2. 200,000 x 9% x 2/12
Sept 1Dr Investment Bonds 200,000 Interest Receivable 3,000 Cr Cash
203,000
Dec. 31Dr Interest Payable 3,000 Interest Expense 6,0001
Cr Cash 9,000
1. 200,000 x 9% x 4/12
Dec. 31Dr Cash 9,000 Cr Interest Revenue
6,000 Interest Receivable
3,000
Solution for Exercise 5.6 (cont.)
Issued at discountEffective interest rate = 11%Price of bondFace value [PV5.5%, 10 200,000 = 0.58543 x 200,000] 117,086Interest [PVOA5.5%, 10 9,000 = 7.53763 x 9,000] 67,839 Present Value 184,925(+) Increment of bond’s value from 30/6 – 1/9 [184,925 x 11% x 2/12] 3,390Cash 188,315(-) Cash paid for interest from 30/6 – 1/9 [200,000 x 9% x 2/12] (3,000)PRICE OF BOND AT 1/9/99 185,315
Solution for Exercise 5.6 (cont.) Journal entries
Sept 1Dr Cash 188,3151
Disc on Bond 14,6852
Cr Interest Payable 3,0003
Bonds Payable 200,0001. 185,315 + 3,000 (interest)2. 200,000 – 185,3153. 200,000 x 9% x 2/12
Sept 1Dr Investment Bonds 185,315 Interest Receivable 3,000 Cr Cash 188,315
Solution for Exercise 5.6 (cont.)
Date CashPaid
InterestExpense
Amortisation of
discount
Discount not
amortised
Carrying amount of
bond
30/6 - - - 15,075 184,925
31/12 9,000 10,171 1,171 13,905 186,096
30/6 9,000 10,235 1,235 12,669 187,331
Solution for Exercise 5.6 (cont.)
Dec. 31Dr Interest Expense 6,7811
Interest Payable 3,000 Cr Disc on Bonds
7812
Cash 9,000
1. 10,171 x 4/62. 1,171 x 4/6, OR: = 186,096 - 185,315 or = 1,171 – (3,390-3,000)
Dec. 31Dr Investment in Bonds 781 Cash 9,000 Cr Interest Revenue 6,781 Interest Receivable 3,000
RETIREMENT OF BONDSBefore the maturity date Examples of bonds retirement:
1. Refunding2. Converted Bond 3. Callable Bond
At the maturity date If bond is retired at the maturity date, no profit or loss is
recordedCarrying Amount of Bond = Face Value of Bond
Journal entry for payment made at the maturity date:Dr Bonds Payable XX Interest Payable XX Cr Cash XX
Discounts on Bonds Payable XX
Refunding
Bond is retired by issuing new bond. At the retirement, all records on bonds and
any related records to the old bond will be eliminated.
Interest expense and amortisation of discount/premium needs to be recorded in advance until the retirement date.
Example
On January 1, 1995, Wira Company issued RM100,000, 10-year bond at par and with stated interest rate of 5% paid every 30/6 and 31/12. On January 1, 1999, the buyer agreed to receive bond of RM90,000, 20-year, with stated interest rate of 8% paid at the same dates. Market interest rate is 8%.
At the issuance of the bond:1/1/95 Dr Cash 100,000
Cr Bonds Payable 100,000 At refundingValue of new issuance of bond = RM90,000 (at par)1/1/99 Dr Bonds Payable – 5% 100,000
Cr Bonds Payable – 8% 90,000 Cr Gains from retirement 10,000
Converted Bonds
Bonds can be converted into shares Reasons for conversion: to increase the share capital or to
make the bond marketable Entries for issuing of the bonds – 2 methods: excess from sale as equity (separate between debts and
equity) the excess is considered as debts (no separation between
debts and equity) Entries for converting bonds to shares: 2 methods:
1. Book value method2. Fair value method
Methods for Converted bondsa) BOOK VALUE METHOD Record of share and premium at book value of bond at
the conversion date No gain/loss is recorded If fair value of shares > book value of bond there is
a decrease in retained earnings
b) FAIR VALUE METHOD Shares and premium are recorded at fair value of the
issued shares Gain/loss is recognized Gain/loss = Fair Value of the shares - Book Value of the
bonds Gain/loss is considered as ordinary item in an Income
Statement
Exercise 5.7: Converted Bonds Tania Company issued at a premium of RM60
a Rm1,000 bond convertible into 10 shares of ordinary shares (par value RM10). At the time of conversion the unamortised premium is RM 50. The market value of the bond is RM1,200 and the shares is quoted on the market at RM120.
Record the journal entries using:1. Book value method2. Fair value method
Book value method
DR Bond payable 1,000
DR Premium on Bond Payable 50
CR Ordinary shares100
CR Premium shares 950
Fair Value Method
DR Bond payable 1,000
DR Premium on Bond Payable 50
DR Loss on Redemption of Bond 150
CR Ordinary shares100
CR Premium shares 1100
Callable Bonds
Normally the bond is repaid at the maturity date. CAN be repaid at any time if it is called up. Normally the bond is callable when the market
interest decline – refinance at lower rate At the callable date, the company should record all
interest expense and amortise the discount/premium until that date.
When the bond is callable, it is retired. Thus, all record of the bonds and any related to it will be eliminated.
Other Instrument for Long Term Liabilities1. Convertible Bonds (CULS)
• Debt securities that are exchangeable into ordinary shares at the option of the holder and under specified terms and conditions
2. Warrants (Transferable Subscription Rights)
• Gives the holder right to subscribe specific number of shares at the pre-determine exercise price and within a specified period of time
Other Instrument for Long Term Liabilities (cont.)
3. Irredeemable Convertible Loan Stocks (ICULS)
Quasi-debt – pay annual coupon over their tenure but ‘irredeemable’ in future, means there will be no repayment of principle at maturity
Mandatory converted Faced value of ICULS will be converted into
new ordinary shares based on stipulated conversion ratio
Exercise 5.9:ICULS On 1 Jan 2002, Tom & Jerry Company
issues RM1 million ICULS 2002/2006 value at RM1.00 per ICULS. The five-year ICULS paid 7.5% coupon per year. This ICULS can be converted into ordinary shares based on conversion ratio of RM5 ICULS for one new shares (RM1.00, par)
Journal entries at issuance and conversion?
Solution for Exercise 5.9
At IssuanceDR Cash 1,000,000
CR ICULS 1,000,000
At Conversion (maturity date)RM1 million ICULS = # shares?New shares = 1,000,000
5= 200,000 units shares
DR ICULS 1,000,000CR Ordinary shares 200,000 CR Premium on shares
800,000