Long-Term Liabilities - Wiley

LEARNING OBJECTIVES

After studying this chapter, youshould be able to:

� Describe the formalprocedures associatedwith issuing long-termdebt.

� Identify various types ofbond issues.

� Describe the accountingvaluation for bonds atdate of issuance.

� Apply the methods of bonddiscount and premiumamortization.

� Describe the accountingprocedures for theextinguishment of debt.

� Explain the accountingprocedures for long-termnotes payable.

� Explain the reporting ofoff-balance-sheetfinancing arrangements.

Indicate how long-termdebt is presented andanalyzed.

Traditionally, investors in the stock and bond marketsoperate in their own separate worlds. However, inrecent volatile markets, even quiet murmurs in thebond market have been amplified into (usuallynegative) movements in stock prices. At one extreme,these gyrations heralded the demise of a companywell before the investors could sniff out the problem.

The swift decline of Enron in late 2001 provided theultimate lesson that a company with no credit is nocompany at all. As one analyst remarked, “You canno longer have an opinion on a company’s stockwithout having an appreciation for its credit rating.”Other energy companies, such as Calpine, NRGEnergy, and AES Corp., also felt the effect ofEnron contagion as lenders tightened or closed down the credit supply and raised interest rates on already-high levels of debt. The result? Stock pricestook a hit.

Other industries are not immune from the negativestock price effects of credit problems. Industrialconglomerate Tyco International felt these effectswhen questions about its merger accounting turnedinto concerns over its debt levels and liquidity. Equityinvestors headed for the exits, driving down the Tycoshare price, even as management was reassuringthem that the company was not in danger of default.Tyco investors were reluctant to believe thereassurances, given the company’s high level of debttaken on to finance its growth through acquisition.This was yet another example of stock prices taking ahit due to concerns about credit quality. Thus, even ifyour investment tastes are in stocks, keep an eye onthe liabilities.1

CHAPTER14CHAPTER14Long-Term Liabilities

Your Debt Is Ki l l ing My Stock

669

1Adapted from Steven Vames, “Credit Quality, Stock In-vesting Go Hand in Hand,” Wall Street Journal (April 1, 2002),p. R4.

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PREVIEW OF CHAPTER 14PREVIEW OF CHAPTER 14As indicated in the opening story, investors are paying considerable attention to theliabilities of companies like Calpine, Tyco, and AES. Companies with high debt lev-els, and with the related impact on income of higher interest costs, are being severelypunished in the stock market. The purpose of this chapter is to explain the accountingissues related to long-term debt.

The content and organization of the chapter are as follows.

Long-term debt consists of probable future sacrifices of economic benefits arising frompresent obligations that are not payable within a year or the operating cycle of the busi-ness, whichever is longer. Bonds payable, long-term notes payable, mortgages payable,pension liabilities, and lease liabilities are examples of long-term liabilities.

Incurring long-term debt is often accompanied by considerable formality. For ex-ample, the bylaws of corporations usually require approval by the board of directorsand the stockholders before bonds can be issued or other long-term debt arrangementscan be contracted.

Generally, long-term debt has various covenants or restrictions for the protectionof both lenders and borrowers. The covenants and other terms of the agreement be-tween the borrower and the lender are stated in the bond indenture or note agreement.Items often mentioned in the indenture or agreement include the amounts authorizedto be issued, interest rate, due date or dates, call provisions, property pledged as se-curity, sinking fund requirements, working capital and dividend restrictions, and limi-tations concerning the assumption of additional debt. Whenever these stipulations areimportant for a complete understanding of the financial position and the results ofoperations, they should be described in the body of the financial statements or the notesthereto.

Although it would seem that these covenants provide adequate protection to thelong-term debt holder, many bondholders suffer considerable losses when additional

670

LONG-TERM LIABILITIES

• Notes issued at facevalue

• Notes not issued atface value

• Special situations• Mortgage notes

payable

Long-Term NotesPayable

• Issuing bonds• Types and ratings• Valuation• Effective interest

method• Costs of issuing• Treasury bonds• Extinguishment

Bonds Payable

• Off-balance-sheetfinancing

• Presentation andanalysis

Reporting andAnalysis of Long-

Term Debt

SECTION 1 B O N D S P AY A B L E

OBJECTIVE �Describe the formalprocedures associatedwith issuing long-termdebt.


debt is added to the capital structure. Consider what happened to bondholders in theleveraged buyout of RJR Nabisco. Solidly rated 93⁄8 percent bonds due in 2016 plunged20 percent in value when management announced the leveraged buyout. Such a lossin value occurs because the additional debt added to the capital structure increases thelikelihood of default. Although bondholders have covenants to protect them, they of-ten are written in a manner that can be interpreted in a number of different ways.

ISSUING BONDSBonds are the most common type of long-term debt reported on a company’s balancesheet. The main purpose of bonds is to borrow for the long term when the amount ofcapital needed is too large for one lender to supply. By issuing bonds in $100, $1,000, or$10,000 denominations, a large amount of long-term indebtedness can be divided intomany small investing units, thus enabling more than one lender to participate in the loan.

A bond arises from a contract known as a bond indenture and represents a prom-ise to pay: (1) a sum of money at a designated maturity rate, plus (2) periodic interestat a specified rate on the maturity amount (face value). Individual bonds are evidencedby a paper certificate and typically have a $1,000 face value. Bond interest paymentsusually are made semiannually, although the interest rate is generally expressed as anannual rate.

An entire bond issue may be sold to an investment banker who acts as a sellingagent in the process of marketing the bonds. In such arrangements, investment bankersmay underwrite the entire issue by guaranteeing a certain sum to the corporation, thustaking the risk of selling the bonds for whatever price they can get (firm underwrit-ing). Or they may sell the bond issue for a commission to be deducted from the pro-ceeds of the sale (best efforts underwriting).

Alternatively, the issuing company may choose to place privately a bond issue byselling the bonds directly to a large institution, financial or otherwise, without the aidof an underwriter (private placement).

TYPES AND RATINGS OF BONDSSome of the more common types of bonds found in practice are:

Types and Ratings of Bonds • 671

OBJECTIVE �Identify various typesof bond issues.

SECURED AND UNSECURED BONDS. Secured bonds are backed by a pledgeof some sort of collateral. Mortgage bonds are secured by a claim on real estate.Collateral trust bonds are secured by stocks and bonds of other corporations.Bonds not backed by collateral are unsecured. A debenture bond is unsecured.A “junk bond” is unsecured and also very risky, and therefore it pays a high in-terest rate. Junk bonds are often used to finance leveraged buyouts.

TERM, SERIAL, AND CALLABLE BONDS. Bond issues that mature on a sin-gle date are called term bonds, and issues that mature in installments are calledserial bonds. Serially maturing bonds are frequently used by school or sanitarydistricts, municipalities, or other local taxing bodies that receive money througha special levy. Callable bonds give the issuer the right to call and retire the bondsprior to maturity.

CONVERTIBLE, COMMODITY-BACKED, AND DEEP DISCOUNT BONDS.If bonds are convertible into other securities of the corporation for a specifiedtime after issuance, they are called convertible bonds. Accounting for bond con-versions is discussed in Chapter 16. Two new types of bonds have been devel-

TYPES OF BONDS


672 • Chapter 14 Long-Term Liabilities

oped in an attempt to attract capital in a tight money market—commodity-backedbonds and deep discount bonds.

Commodity-backed bonds (also called asset-linked bonds) are redeemablein measures of a commodity, such as barrels of oil, tons of coal, or ounces of raremetal. To illustrate, Sunshine Mining, a silver mining producer, sold two issuesof bonds redeemable with either $1,000 in cash or 50 ounces of silver, whicheveris greater at maturity, and that have a stated interest rate of 81⁄2 percent. Theaccounting problem is one of projecting the maturity value, especially since sil-ver has fluctuated between $4 and $40 an ounce since issuance.

JCPenney Company sold the first publicly marketed long-term debt securi-ties in the United States that do not bear interest. These deep discount bonds,also referred to as zero-interest debenture bonds, are sold at a discount that pro-vides the buyer’s total interest payoff at maturity.

REGISTERED AND BEARER (COUPON) BONDS. Bonds issued in the nameof the owner are registered bonds and require surrender of the certificate and is-suance of a new certificate to complete a sale. A bearer or coupon bond, how-ever, is not recorded in the name of the owner and may be transferred from oneowner to another by mere delivery.

INCOME AND REVENUE BONDS. Income bonds pay no interest unless theissuing company is profitable. Revenue bonds, so called because the interest onthem is paid from specified revenue sources, are most frequently issued by air-ports, school districts, counties, toll-road authorities, and governmental bodies.

One of the more interesting recent innovations in the bond market is bonds whose in-terest payments are tied to changes in the weather. To understand how these weatherbonds work, let’s look at a recent bond issue by Koch Industries. Koch provides energyto utilities, distributors, and others around the country. It feels the heat financially whenweather is colder than expected and the company has to buy energy in the open mar-ket to serve its clients. It also can experience losses if the weather is warmer than usual.

Koch structured a bond offering designed to deal with this problem. With Koch’s bonds,if the weather is colder than normal, the interest rate drops 1⁄2 percent for each one-quarter degree decline in average temperature. Conversely, the rate goes up by 1⁄2 percentif the weather is warmer by one-quarter of a degree. Investors even lose some of theiroriginal investment (principal) if weather deviates significantly from the average. How-ever, certain investors like these risky bonds because they add diversification to theirportfolios. Mother Nature, rather than economic factors, affects the bond value, thusproviding diversification.

Although weather bonds may sound unusual, more and more companies are issuingcatastrophe-type bonds. For example, insurance companies are issuing bonds to protectthemselves from catastrophes such as earthquakes and storms. Besides financial condi-tions, it seems that investors must now be concerned with meteorological matters as well.

Source: Adapted from Gregory Zuckerman and Deborah Lohse, “Weather Bonds Hedge AgainstMother Nature’s Profit Effects,” Wall Street Journal (October 26, 1999), p. C1.

What do thenumbers mean?

How’s the weather?

OBJECTIVE �Describe theaccounting valuationfor bonds at date ofissuance.

VALUATION OF BONDS PAYABLE—DISCOUNT AND PREMIUMThe issuance and marketing of bonds to the public does not happen overnight. It usu-ally takes weeks or even months. Underwriters must be arranged, Securities and Ex-change Commission approval must be obtained, audits and issuance of a prospectus


Valuation of Bonds Payable—Discount and Premium • 673

may be required, and certificates must be printed. Frequently, the terms in a bond in-denture are established well in advance of the sale of the bonds. Between the time theterms are set and the bonds are issued, the market conditions and the financial posi-tion of the issuing corporation may change significantly. Such changes affect the mar-ketability of the bonds and thus their selling price.

The selling price of a bond issue is set by such familiar phenomena as supply anddemand among buyers and sellers, relative risk, market conditions, and the state of theeconomy. The investment community values a bond at the present value of its futurecash flows, which consist of (1) interest and (2) principal. The rate used to compute thepresent value of these cash flows is the interest rate that provides an acceptable returnon an investment commensurate with the issuer’s risk characteristics.

The interest rate written in the terms of the bond indenture (and ordinarily printedon the bond certificate) is known as the stated, coupon, or nominal rate. This rate,which is set by the issuer of the bonds, is expressed as a percentage of the face value,also called the par value, principal amount, or maturity value, of the bonds. If the rateemployed by the investment community (buyers) differs from the stated rate, the pres-ent value of the bonds computed by the buyers will differ from the face value of thebonds. That present value becomes the bond’s current purchase price. The differencebetween the face value and the present value of the bonds is either a discount or pre-mium.2 If the bonds sell for less than face value, they are sold at a discount. If the bondssell for more than face value, they are sold at a premium.

The rate of interest actually earned by the bondholders is called the effective yield,or market rate. If bonds sell at a discount, the effective yield is higher than the statedrate. Conversely, if bonds sell at a premium, the effective yield is lower than the statedrate. While the bond is outstanding, its price is affected by several variables, most no-tably the market rate of interest. There is an inverse relationship between the marketinterest rate and the price of the bond.

To illustrate the computation of the present value of a bond issue, assume thatServiceMaster issues $100,000 in bonds, due in 5 years with 9 percent interest payableannually at year-end. At the time of issue, the market rate for such bonds is 11 percent.The following time diagram depicts both the interest and the principal cash flows.

2Until the 1950s it was common for corporations to issue bonds with low, even-percentagecoupons (such as 4 percent) to demonstrate their financial solidity. Frequently, the result waslarge discounts. More recently, it has become acceptable to set the stated rate of interest on bondsin rather precise fractions (such as 107⁄8 percent). Companies usually attempt to align the statedrate as closely as possible with the market or effective rate at the time of issue. While discountsand premiums continue to occur, their absolute magnitude tends to be much smaller; many timesit is immaterial. Professor Bill N. Schwartz (Virginia Commonwealth University) studied the 685new debt offerings in 1985. Of these, none were issued at a premium. Approximately 95 percentwere issued either with no discount or at a price above 98. Now, however, zero-interest (deepdiscount) bonds are more popular, and they cause substantial discounts.

4n = 5

i = 11%

2 3 50 1

$9,000 Interest

$100,000 Principal

$9,000$9,000$9,000$9,000PVPV –– OAOA

PVPVPV

PV–OA

The actual principal and interest cash flows are discounted at an 11 percent ratefor 5 periods as shown in Illustration 14-1.

International Insight

Valuation of long-term debtvaries internationally. In theU.S., discount and premium arebooked and amortized over thelife of the debt. In some coun-tries (e.g., Sweden, Japan, Bel-gium), it is permissible to writeoff the discount and premiumimmediately.

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By paying $92,608.10 at the date of issue, the investors will realize an effective rate or yield of 11 percent over the 5-year term of the bonds. These bonds would sell at adiscount of $7,391.90 ($100,000 � $92,608.10). The price at which the bonds sell is typically stated as a percentage of the face or par value of the bonds. For example, the ServiceMaster bonds sold for 92.6 (92.6% of par). If ServiceMaster had received$102,000, we would say the bonds sold for 102 (102% of par).

When bonds sell below face value, it means that investors demand a rate of inter-est higher than the stated rate. The investors are not satisfied with the stated rate becausethey can earn a greater rate on alternative investments of equal risk. They cannot changethe stated rate, so they refuse to pay face value for the bonds. By changing the amountinvested, they alter the effective rate of interest. The investors receive interest at thestated rate computed on the face value, but they are earning at an effective rate thatis higher than the stated rate because they paid less than face value for the bonds.(An illustration for a bond that sells at a premium is shown later in the chapter, inIllustrations 14-5 and 14-6.)

ILLUSTRATION 14-1Present ValueComputation of BondSelling at a Discount

Present value of the principal:$100,000 � .59345 (Table 6-2) $59,345.00

Present value of the interest payments:$9,000 � 3.69590 (Table 6-4) 33,263.10

Present value (selling price) of the bonds $92,608.10

Two major publication companies, Moody’s Investors Service and Standard & Poor’sCorporation, issue quality ratings on every public debt issue. The following table sum-marizes the ratings issued by Standard & Poor’s, along with historical default rates onbonds with different ratings. As expected, bonds receiving the highest quality rating ofAAA have the lowest historical default rates. And bonds rated below BBB, which areconsidered below investment grade (“junk bonds”) experience default rates rangingfrom 20 to 50 percent.

Original Rating Default Rate*

AAA 0.52%AA 1.31A 2.32BBB 6.64BB 19.52B 35.76CCC 54.38

*Percentage of defaults by issuers rated by Standard & Poor’s over the past 15 years, based on rating they wereinitially assigned.Data: Standard & Poor’s Corp.

Because debt ratings reflect credit quality, they are closely monitored by the marketwhen determining the required yield and pricing of bonds at issuance. For example, inlate 2001, the spreads in the required yields between corporate investment grade andjunk bonds ranged from 6 to 8 percent. For a company such as WorldCom, which is-sued over $11 billion in debt in 2001, every 1 percent of yield it saves by maintaining ahigher credit rating translates into over $100 million dollars of reduced interest expense.Thus, it is not surprising that companies also keep a close watch on their credit rating.

Source: A. Borrus, M. McNamee, and H. Timmons, “The Credit Raters: How They Work and HowThey Might Work Better,” Business Week (April 8, 2002), pp. 38–40.


How’s my rating?


Valuation of Bonds Payable—Discount and Premium • 675

Bonds Issued at Par on Interest DateWhen bonds are issued on an interest payment date at par (face value), no interest hasaccrued and no premium or discount exists. The accounting entry is made simply forthe cash proceeds and the face value of the bonds. To illustrate, if 10-year term bondswith a par value of $800,000, dated January 1, 2004, and bearing interest at an annualrate of 10 percent payable semiannually on January 1 and July 1, are issued on January 1at par, the entry on the books of the issuing corporation would be:

Cash 800,000Bonds Payable 800,000

The entry to record the first semiannual interest payment of $40,000 ($800,000 �.10 � 1/2) on July 1, 2004, would be as follows.

Bond Interest Expense 40,000Cash 40,000

The entry to record accrued interest expense at December 31, 2004 (year-end) wouldbe as follows.

Bond Interest Expense 40,000Bond Interest Payable 40,000

Bonds Issued at Discount or Premium on Interest DateIf the $800,000 of bonds illustrated above were issued on January 1, 2004, at 97 (mean-ing 97% of par), the issuance would be recorded as follows.

Cash ($800,000 � .97) 776,000Discount on Bonds Payable 24,000

Bonds Payable 800,000

Because of its relation to interest, as previously discussed, the discount is amor-tized and charged to interest expense over the period of time that the bonds are out-standing. Under the straight-line method,3 the amount amortized each year is a con-stant amount. For example, using the bond discount above of $24,000, the amountamortized to interest expense each year for 10 years is $2,400 ($24,000 � 10 years), andif amortization is recorded annually, it is recorded as follows.

Bond Interest Expense 2,400Discount on Bonds Payable 2,400

At the end of the first year, 2004, as a result of the amortization entry above, the un-amortized balance in Discount on Bonds Payable is $21,600 ($24,000 � $2,400).

If the bonds were dated and sold on October 1, 2004, and if the fiscal year of thecorporation ended on December 31, the discount amortized during 2004 would be only3/12 of 1/10 of $24,000, or $600. Three months of accrued interest must also be recordedon December 31.

Premium on Bonds Payable is accounted for in a manner similar to that for Dis-count on Bonds Payable. If the 10-year bonds of a par value of $800,000 are dated andsold on January 1, 2004, at 103, the following entry is made to record the issuance.

Cash ($800,000 � 1.03) 824,000Premium on Bonds Payable 24,000Bonds Payable 800,000

3Although the effective interest method is preferred for amortization of discount or pre-mium, to keep these initial illustrations simple, we have chosen to use the straight-line method(which is acceptable if the results obtained are not materially different from those produced bythe effective interest method).

OBJECTIVE �Apply the methods ofbond discount andpremium amortization.



At the end of 2004 and for each year the bonds are outstanding, the entry to amor-tize the premium on a straight-line basis is:

Premium on Bonds Payable 2,400Bond Interest Expense 2,400

Bond interest expense is increased by amortization of a discount and decreased byamortization of a premium. Amortization of a discount or premium under the effec-tive interest method is discussed later.

Some bonds are callable by the issuer after a certain date at a stated price. This callfeature gives the issuing corporation the opportunity to reduce its bonded indebtednessor take advantage of lower interest rates. Whether callable or not, any premium ordiscount must be amortized over the life to maturity date because early redemption(call of the bond) is not a certainty.

Bonds Issued between Interest DatesBond interest payments are usually made semiannually on dates specified in the bondindenture. When bonds are issued on other than the interest payment dates, buyers ofthe bonds will pay the seller the interest accrued from the last interest payment dateto the date of issue. The purchasers of the bonds, in effect, pay the bond issuer in ad-vance for that portion of the full 6-months’ interest payment to which they are not en-titled, not having held the bonds during that period. The purchasers will receive thefull 6-months’ interest payment on the next semiannual interest payment date.

To illustrate, if 10-year bonds of a par value of $800,000, dated January 1, 2004, andbearing interest at an annual rate of 10 percent payable semiannually on January 1 andJuly 1, are issued on March 1, 2004, at par plus accrued interest, the entry on the booksof the issuing corporation is:

Cash 813,333Bonds Payable 800,000Bond Interest Expense ($800,000 � .10 � 2/12) 13,333(Interest Payable might be credited instead)

The purchaser advances 2 months’ interest, because on July 1, 2004, 4 months af-ter the date of purchase, 6 months’ interest will be received from the issuing company.The company makes the following entry on July 1, 2004.

Bond Interest Expense 40,000Cash 40,000

The expense account now contains a debit balance of $26,667, which represents theproper amount of interest expense, 4 months at 10 percent on $800,000.

The illustration above was simplified by having the January 1, 2004, bonds issuedon March 1, 2004, at par. If, however, the 10 percent bonds were issued at 102, the en-try on March 1 on the books of the issuing corporation would be:

Cash [($800,000 � 1.02) � ($800,000 � .10 � 2/12)] 829,333Bonds Payable 800,000Premium on Bonds Payable ($800,000 � .02) 16,000Bond Interest Expense 13,333

The premium would be amortized from the date of sale, March 1, 2004, not from thedate of the bonds, January 1, 2004.

EFFECTIVE INTEREST METHODThe profession’s preferred procedure for amortization of a discount or premium is theeffective interest method (also called present value amortization). Under the effectiveinterest method:


Effective Interest Method • 677

� Bond interest expense is computed first by multiplying the carrying value4 of thebonds at the beginning of the period by the effective interest rate.

� The bond discount or premium amortization is then determined by comparing thebond interest expense with the interest to be paid.

The computation of the amortization is depicted graphically as follows.

ILLUSTRATION 14-3Computation of Discounton Bonds Payable

ILLUSTRATION 14-2Bond Discount andPremium AmortizationComputation

Maturity value of bonds payable $100,000Present value of $100,000 due in 5 years at 10%, interest payable

semiannually (Table 6-2); FV(PVF10,5%); ($100,000 � .61391) $61,391Present value of $4,000 interest payable semiannually for 5 years at

10% annually (Table 6-4); R(PVF-OA10,5%); ($4,000 � 7.72173) 30,887

Proceeds from sale of bonds 92,278

Discount on bonds payable $ 7,722

The effective interest method produces a periodic interest expense equal to a con-stant percentage of the carrying value of the bonds. Since the percentage is the effec-tive rate of interest incurred by the borrower at the time of issuance, the effective in-terest method results in a better matching of expenses with revenues than does thestraight-line method.

Both the effective interest and straight-line methods result in the same total amountof interest expense over the term of the bonds, and the annual amounts of interestexpense are generally quite similar. However, when the annual amounts are materi-ally different, the effective interest method is required under generally acceptedaccounting principles.

Bonds Issued at a DiscountTo illustrate amortization of a discount, Evermaster Corporation issued $100,000 of8 percent term bonds on January 1, 2004, due on January 1, 2009, with interest payableeach July 1 and January 1. Because the investors required an effective interest rate of10 percent, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. The$7,722 discount is computed as follows.5

AmortizationAmount

Carrying Valueof Bonds at

Beginning of Period

EffectiveInterest

Rate×

Bond Interest Expense

Face Amountof

Bonds

StatedInterest

Rate×

Bond Interest Paid

––– ===

Illustration 14-4 (on page 678) provides a schedule of bond discount amortization overa 5-year period.

4The book value, also called the carrying value, equals the face amount minus any un-amortized discount or plus any unamortized premium.

5Because interest is paid semiannually, the interest rate used is 5 percent (10% � 6⁄12). Thenumber of periods is 10 (5 years � 2).



The entry to record the issuance of Evermaster Corporation’s bonds at a discounton January 1, 2004, is:

Cash 92,278Discount on Bonds Payable 7,722

Bonds Payable 100,000

The journal entry to record the first interest payment on July 1, 2004, and amortizationof the discount is:

Bond Interest Expense 4,614Discount on Bonds Payable 614Cash 4,000

The journal entry to record the interest expense accrued at December 31, 2004 (year-end) and amortization of the discount is:

Bond Interest Expense 4,645Bond Interest Payable 4,000Discount on Bonds Payable 645

Bonds Issued at a PremiumIf the market had been such that the investors were willing to accept an effective in-terest rate of 6 percent on the bond issue described above, they would have paid$108,530 or a premium of $8,530, computed as follows.

SCHEDULE OF BOND DISCOUNT AMORTIZATIONEFFECTIVE INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS

5-YEAR, 8% BONDS SOLD TO YIELD 10%

CarryingCash Interest Discount Amount

Date Paid Expense Amortized of Bonds

1/1/04 $ 92,278 7/1/04 $ 4,000a $ 4,614b $ 614c 92,892d

1/1/05 4,000 4,645 645 93,537 7/1/05 4,000 4,677 677 94,214 1/1/06 4,000 4,711 711 94,925 7/1/06 4,000 4,746 746 95,671 1/1/07 4,000 4,783 783 96,454 7/1/07 4,000 4,823 823 97,277 1/1/08 4,000 4,864 864 98,141 7/1/08 4,000 4,907 907 99,048 1/1/09 4,000 4,952 952 100,000

$40,000 $47,722 $7,722

a$4,000 � $100,000 �.08 � 6/12 c$614 � $4,614 � $4,000b$4,614 � $92,278 �.10 � 6/12 d$92,892 � $92,278 � $614

ILLUSTRATION 14-4Bond DiscountAmortization Schedule

Calculator Solution forPresent Valueof Bonds:

N

Inputs

10

I/YR 5

PV ?

PMT –4,000

FV –100,000

92,278

Answer

ILLUSTRATION 14-5Computation of Premiumon Bonds Payable

Maturity value of bonds payable $100,000Present value of $100,000 due in 5 years at 6%, interest payable

semiannually (Table 6-2); FV(PVF10,3%); ($100,000 � .74409) $74,409Present value of $4,000 interest payable semiannually for 5 years

at 6% annually (Table 6-4); R(PVF-OA10,3%); ($4,000 � 8.53020) 34,121

Proceeds from sale of bonds 108,530

Premium on bonds payable $ 8,530

Illustration 14-6 (on page 679) provides a schedule of bond premium amortization overa 5-year period.


Effective Interest Method • 679

The entry to record the issuance of Evermaster bonds at a premium on January 1,2004, is:

Cash 108,530Premium on Bonds Payable 8,530Bonds Payable 100,000

The journal entry to record the first interest payment on July 1, 2004, and amorti-zation of the premium is:

Bond Interest Expense 3,256Premium on Bonds Payable 744

Cash 4,000

The discount or premium should be amortized as an adjustment to interest expenseover the life of the bond in such a way as to result in a constant rate of interest whenapplied to the carrying amount of debt outstanding at the beginning of any given pe-riod.6 Although the effective interest method is recommended, the straight-line methodis permitted if the results obtained are not materially different from those produced bythe effective interest method.

Accruing InterestIn our previous examples, the interest payment dates and the date the financial state-ments were issued were the same. For example, when Evermaster sold bonds at a pre-mium (page 677), the two interest payment dates coincided with the financial report-ing dates. However, what happens if Evermaster wishes to report financial statementsat the end of February 2004? In this case, the premium is prorated by the appropriatenumber of months to arrive at the proper interest expense as follows.

SCHEDULE OF BOND PREMIUM AMORTIZATIONEFFECTIVE INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS

5-YEAR, 8% BONDS SOLD TO YIELD 6%

CarryingCash Interest Premium Amount

Date Paid Expense Amortized of Bonds

1/1/04 $108,530 7/1/04 $ 4,000a $ 3,256b $ 744c 107,786d

1/1/05 4,000 3,234 766 107,020 7/1/05 4,000 3,211 789 106,231 1/1/06 4,000 3,187 813 105,418 7/1/06 4,000 3,162 838 104,580 1/1/07 4,000 3,137 863 103,717 7/1/07 4,000 3,112 888 102,829 1/1/08 4,000 3,085 915 101,914 7/1/08 4,000 3,057 943 100,971 1/1/09 4,000 3,029 971 100,000

$40,000 $31,470 $8,530

a$4,000 � $100,000 � .08 � 6/12 c$744 � $4,000 � $3,256b$3,256 � $108,530 � .06 � 6/12 d$107,786 � $108,530 � $744

ILLUSTRATION 14-6Bond PremiumAmortization Schedule

Calculator Solution forPresent Valueof Bonds:

N

Inputs

10

I/YR 3

PV ?

PMT –4,000

FV –100,000

108,530

Answer

ILLUSTRATION 14-7Computation of InterestExpense

Interest accrual ($4,000 � 2/6) $1,333.33 Premium amortized ($744 � 2/6) (248.00)

Interest expense (Jan.–Feb.) $1,085.33

6“Interest on Receivables and Payables,” Opinions of the Accounting Principles Board No. 21(New York: AICPA, 1971), par. 16.



The journal entry to record this accrual is as follows.

Bond Interest Expense 1,085.33Premium on Bonds Payable 248.00

Bond Interest Payable 1,333.33

If the company prepares financial statements 6 months later, the same procedureis followed. That is, the premium amortized would be as follows.

ILLUSTRATION 14-8Computation of PremiumAmortization

Premium amortized (March–June) ($744 � 4/6) $496.00Premium amortized (July–August) ($766 � 2/6) 255.33

Premium amortized (March–August 2004) $751.33

The computation is much simpler if the straight-line method is employed. Forexample, in the Evermaster situation, the total premium is $8,530, which is allocatedevenly over the 5-year period. Thus, premium amortization per month is $142.17 ($8,530� 60 months).

Classification of Discount and PremiumDiscount on bonds payable is not an asset because it does not provide any future eco-nomic benefit. The enterprise has the use of the borrowed funds, but must pay inter-est for that use. A bond discount means that the company borrowed less than the faceor maturity value of the bond and therefore is faced with an actual (effective) interestrate higher than the stated (nominal) rate. Conceptually, discount on bonds payable isa liability valuation account. That is, it is a reduction of the face or maturity amountof the related liability.7 This account is referred to as a contra account.

Premium on bonds payable has no existence apart from the related debt. The lowerinterest cost results because the proceeds of borrowing exceed the face or maturityamount of the debt. Conceptually, premium on bonds payable is a liability valuationaccount. That is, it is an addition to the face or maturity amount of the related liabil-ity.8 This account is referred to as an adjunct account. As a result, the profession re-quires that bond discount and bond premium be reported as a direct deduction fromor addition to the face amount of the bond.

COSTS OF ISSUING BONDSThe issuance of bonds involves engraving and printing costs, legal and accounting fees,commissions, promotion costs, and other similar charges. According to APB OpinionNo. 21, these items should be debited to a deferred charge account (asset) for Un-amortized Bond Issue Costs and amortized over the life of the debt, in a manner simi-lar to that used for discount on bonds.9

The FASB, however, in Concepts Statement No. 6 takes the position that debt issuecost can be treated as either an expense or a reduction of the related debt liability. Debtissue cost is not considered an asset because it provides no future economic benefit.The cost of issuing bonds, in effect, reduces the proceeds of the bonds issued and in-

7“Elements of Financial Statements of Business Enterprises,” Statement of Financial Account-ing Concepts No. 6 (Stamford, Conn.: FASB, 1985), par. 236.

8Ibid., par. 238.9“Interest on Receivables and Payables,” op. cit., par. 15.


Extinguishment of Debt • 681

creases the effective interest rate. Thus it may be accounted for the same as the un-amortized discount.

There is an obvious difference between GAAP and Concepts Statement No. 3’s viewof debt issue costs. Until a standard is issued to supersede Opinion No. 21, however,acceptable GAAP for debt issue costs is to treat them as a deferred charge and amor-tize them over the life of the debt.

To illustrate the accounting for costs of issuing bonds, assume that Microchip Cor-poration sold $20,000,000 of 10-year debenture bonds for $20,795,000 on January 1, 2005(also the date of the bonds). Costs of issuing the bonds were $245,000. The entries atJanuary 1, 2005, and December 31, 2005, for issuance of the bonds and amortization ofthe bond issue costs would be as follows.

January 1, 2005

Cash 20,550,000Unamortized Bond Issue Costs 245,000

Premium on Bonds Payable 795,000Bonds Payable 20,000,000

(To record issuance of bonds)

December 31, 2005

Bond Issue Expense 24,500Unamortized Bond Issue Costs 24,500

(To amortize one year of bond issuecosts—straight-line method)

Although the bond issue costs should be amortized using the effective interestmethod, the straight-line method is generally used in practice because it is easier andthe results are not materially different.

TREASURY BONDSBonds payable that have been reacquired by the issuing corporation or its agent ortrustee and have not been canceled are known as treasury bonds. They should be shownon the balance sheet at par value—as a deduction from the bonds payable issued, toarrive at a net figure representing bonds payable outstanding. When they are sold orcanceled, the Treasury Bonds account should be credited.

EXTINGUISHMENT OF DEBTHow is the payment of debt—often referred to as extinguishment of debt—recorded?If the bonds (or any other form of debt security) are held to maturity, the answer isstraightforward: No gain or loss is computed. Any premium or discount and any issuecosts will be fully amortized at the date the bonds mature. As a result, the carryingamount will be equal to the maturity (face) value of the bond. Because the maturity orface value is also equal to the bond’s market value at that time, no gain or loss exists.

In some cases, debt is extinguished before its maturity date.10 The amount paid onextinguishment or redemption before maturity, including any call premium and ex-

10Some companies have attempted to extinguish debt through an in-substance defeasance.In-substance defeasance is an arrangement whereby a company provides for the future repay-ment of one or more of its long-term debt issues by placing purchased securities in an irrevoca-ble trust, the principal and interest of which are pledged to pay off the principal and interest ofits own debt securities as they mature. The company, however, is not legally released from itsprimary obligation for the debt that is still outstanding. In some cases, debt holders are not evenaware of the transaction and continue to look to the company for repayment. This practice is notconsidered an extinguishment of debt, and therefore no gain or loss is recorded.

OBJECTIVE �Describe theaccounting proceduresfor the extinguishmentof debt.



pense of reacquisition, is called the reacquisition price. On any specified date, the netcarrying amount of the bonds is the amount payable at maturity, adjusted for un-amortized premium or discount and cost of issuance. Any excess of the net carryingamount over the reacquisition price is a gain from extinguishment. In contrast, the ex-cess of the reacquisition price over the net carrying amount is a loss from extinguish-ment. At the time of reacquisition, the unamortized premium or discount, and anycosts of issue applicable to the bonds, must be amortized up to the reacquisitiondate.

To illustrate, assume that on January 1, 1994, General Bell Corp. issued bonds witha par value of $800,000 at 97, due in 20 years. Bond issue costs totaling $16,000 wereincurred. Eight years after the issue date, the entire issue is called at 101 and canceled.11

The loss on redemption (extinguishment) is computed as follows. (Straight-line amor-tization is used for simplicity.)

ILLUSTRATION 14-9Computation of Loss onRedemption of Bonds

Reacquisition price ($800,000 � 1.01) $808,000Net carrying amount of bonds redeemed:

Face value $800,000 Unamortized discount ($24,000* � 12/20) (14,400)Unamortized issue costs ($16,000 � 12/20)

(both amortized using straight-line basis) (9,600) 776,000

Loss on redemption $ 32,000

*[$800,000 � (1 � .97)]

The entry to record the reacquisition and cancellation of the bonds is:

Bonds Payable 800,000Loss on Redemption of Bonds 32,000

Discount on Bonds Payable 14,400Unamortized Bond Issue Costs 9,600Cash 808,000

It is often advantageous for the issuing corporation to acquire the entire outstand-ing bond issue and replace it with a new bond issue bearing a lower rate of interest.The replacement of an existing issuance with a new one is called refunding. Whetherthe early redemption or other extinguishment of outstanding bonds is a non-refundingor a refunding situation, the difference (gain or loss) between the reacquisition priceand the net carrying amount of the redeemed bonds should be recognized currently inincome of the period of redemption.12

11The issuer of callable bonds is generally required to exercise the call on an interest date.Therefore, the amortization of any discount or premium will be up to date and there will be noaccrued interest. However, early extinguishments through purchases of bonds in the open mar-ket are more likely to be on other than an interest date. If the purchase is not made on an inter-est date, the discount or premium must be amortized and the interest payable must be accruedfrom the last interest date to the date of purchase.

12Until recently, gains and losses on extinguishment of debt were reported as extraordinaryitems. In response to concerns that such gains or losses are neither unusual nor infrequent, theFASB eliminated extraordinary item treatment for extinguishment of debt. “Recission of FASBStatements No. 4, 44, and 64 and Technical Corrections,” Statement of Financial Accounting Stan-dards No. 145 (Norwalk, Conn.: FASB, 2002).


Extinguishment of Debt • 683

The difference between current notes payable and long-term notes payable is the ma-turity date. As discussed in Chapter 13, short-term notes payable are expected to bepaid within a year or the operating cycle—whichever is longer. Long-term notes aresimilar in substance to bonds in that both have fixed maturity dates and carry either astated or implicit interest rate. However, notes do not trade as readily as bonds in theorganized public securities markets. Noncorporate and small corporate enterprises is-sue notes as their long-term instruments. In contrast, larger corporations issue bothlong-term notes and bonds.

Accounting for notes and bonds is quite similar. Like a bond, a note is valued atthe present value of its future interest and principal cash flows, with any discountor premium being similarly amortized over the life of the note.13 The computation

L O N G - T E R M N O T E S P AY A B L E SECTION 2

As shown in the following charts, growth of U.S. corporate and consumer debt is out-pacing the growth in assets. This increase in debt levels is sparking some concern forstock prices, with corporate debt exceeding $4.9 trillion and consumer debt exceeding$7.5 trillion in 2001. Both are more than twice their 1989 levels.

Growth Rates for Corporate and Consumer Debt and Assets

Increasing debt levels can be good indicators of the vibrancy of the economy, especiallywhen the borrowed money is used to expand productive capacity or communications net-works to better serve growing customer demand. Unfortunately, a substantial amount ofthe money borrowed by corporations in the recent debt run-up was used in share buy-backs, some of which were used to compensate management via stock option plans.

Source: Adapted from Gregory Zuckerman, “Climb of Corporate Debt Trips Analysts’ Alarm,” Wall

Street Journal (December 31, 2001), p. C1.


More debt, please

OBJECTIVE �Explain the accountingprocedures for long-term notes payable.

13According to APB Opinion No. 21, all payables that represent commitments to pay moneyat a determinable future date are subject to present value measurement techniques, except forthe following specifically excluded types:

1. Normal accounts payable due within one year.2. Security deposits, retainages, advances, or progress payments.3. Transactions between parent and subsidiary.4. Convertible debt securities.5. Obligations payable at some indeterminable future date.

1990

Household

15

20%

10

5

0

−5

−10'92 '94 '96 '98 '00 '011990

Corporate

10

15

20%

5

0

−5

−10'92 '94 '96 '98 '00 '01

Credit-market debt

Assets



of the present value of an interest-bearing note, the recording of its issuance, and theamortization of any discount or premium and accrual of interest are as shown for bondson pages 673–680 of this chapter.

As you might expect, accounting for long-term notes payable parallels accountingfor long-term notes receivable as was presented in Chapter 7.

NOTES ISSUED AT FACE VALUEIn Chapter 7, we discussed the recognition of a $10,000, 3-year note issued at face valueby Scandinavian Imports to Bigelow Corp. In this transaction, the stated rate and the ef-fective rate were both 10 percent. The time diagram and present value computation onpage 327 of Chapter 7 (see Illustration 7-8) for Bigelow Corp. would be the same for theissuer of the note, Scandinavian Imports, in recognizing a note payable. Because the pres-ent value of the note and its face value are the same, $10,000, no premium or discount isrecognized. The issuance of the note is recorded by Scandinavian Imports as follows.

Cash 10,000Notes Payable 10,000

Scandinavian Imports would recognize the interest incurred each year as follows.

Interest Expense 1,000Cash 1,000

NOTES NOT ISSUED AT FACE VALUE

Zero-Interest-Bearing NotesIf a zero-interest-bearing (non-interest-bearing) note14 is issued solely for cash, its pres-ent value is measured by the cash received by the issuer of the note. The implicit in-terest rate is the rate that equates the cash received with the amounts received in thefuture. The difference between the face amount and the present value (cash received)is recorded as a discount and amortized to interest expense over the life of the note.

An example of such a transaction is Beneficial Corporation’s offering of $150 mil-lion of zero-coupon notes (deep discount bonds) having an 8-year life. With a face valueof $1,000 each, these notes sold for $327—a deep discount of $673 each. The presentvalue of each note is the cash proceeds of $327. The interest rate can be calculated bydetermining the interest rate that equates the amount currently paid by the investorwith those amounts to be received in the future. Thus, Beneficial amortized the dis-count over the 8-year life of the notes using an effective interest rate of 15 percent.15

To illustrate the entries and the amortization schedule, assume that your companyis the one that issued the 3-year, $10,000, zero-interest-bearing note to Jeremiah Com-pany as illustrated on page 328 of Chapter 7 (notes receivable). The implicit rate thatequated the total cash to be paid ($10,000 at maturity) to the present value of the fu-ture cash flows ($7,721.80 cash proceeds at date of issuance) was 9 percent (The pres-ent value of $1 for 3 periods at 9 percent is $0.77218.) The time diagram depicting theone cash flow is shown at the top of page 684.

Inputs Answer

N 8

I/YR ?

PV -327

PMT 0

FV 1,000

15

Calculator Solution forEffective Intereston Note:

14Although the term “note” is used throughout this discussion, the basic principles andmethodology are equally applicable to other long-term debt instruments.

15 $327 � $1,000 (PVF8,i)

PVF8,i � � .327

.327 � 15% (in Table 6-2 locate .32690).

$327�$1,000


Notes Not Issued at Face Value • 685

Your entry to record issuance of the note is as follows.

Cash 7,721.80Discount on Notes Payable 2,278.20

Notes Payable 10,000.00

The discount is amortized and interest expense is recognized annually using theeffective interest method. The 3-year discount amortization and interest expense sched-ule is shown in Illustration 14-10. (This schedule is similar to the note receivable sched-ule of Jeremiah Company in Illustration 7-9.)

n = 3

i = 9%

2 30 1

$0 Interest

$10,000 PrincipalPVPV

PVPV––OAOA $0$0PV–OA

PV

ILLUSTRATION 14-10Schedule of NoteDiscount Amortization

SCHEDULE OF NOTE DISCOUNT AMORTIZATIONEFFECTIVE INTEREST METHOD0% NOTE DISCOUNTED AT 9%

CarryingCash Interest Discount AmountPaid Expense Amortized of Note

Date of issue $ 7,721.80 End of year 1 $–0– $ 694.96a $ 694.96b 8,416.76c

End of year 2 –0– 757.51 757.51 9,174.27 End of year 3 –0– 825.73d 825.73 10,000.00

$–0– $2,278.20 $2,278.20

a$7,721.80 � .09 � $694.96 c$7,721.80 � $694.96 � $8,416.76b$694.96 � 0 � $694.96 d5¢ adjustment to compensate for rounding

Interest expense at the end of the first year using the effective interest method isrecorded as follows.

Interest Expense ($7,721.80 � 9%) 694.96Discount on Notes Payable 694.96

The total amount of the discount, $2,278.20 in this case, represents the expense to beincurred on the note over the 3 years.

Interest-Bearing NotesThe zero-interest-bearing note above is an example of the extreme difference betweenthe stated rate and the effective rate. In many cases, the difference between these ratesis not so great. Take, for example, the illustration from Chapter 7 where Marie Co.issued a $10,000, 3-year note bearing interest at 10 percent to Morgan Corp. for cash.The market rate of interest for a note of similar risk is 12 percent. The time diagramdepicting the cash flows and the computation of the present value of this note are shownon page 329 (Illustration 7-10). In this case, because the effective rate of interest (12%)is greater than the stated rate (10%), the present value of the note is less than the facevalue. That is, the note is exchanged at a discount. The issuance of the note is recordedby Marie Co. as follows.

Cash 9,520Discount on Notes Payable 480

Notes Payable 10,000


Payment of the annual interest and amortization of the discount for the first year arerecorded by Marie Co. as follows (amounts per amortization schedule).

Interest Expense 1,142Discount on Bonds Payable 142Cash 1,000

When the present value exceeds the face value, the note is exchanged at a premium.The premium on a note payable is recorded as a credit and amortized using the effec-tive interest method over the life of the note as annual reductions in the amount of in-terest expense recognized.

SPECIAL NOTES PAYABLE SITUATIONS

Notes Issued for Property, Goods, and ServicesSometimes, when a note is issued, property, goods, or services may be received. Whenthe debt instrument is exchanged for property, goods, or services in a bargained trans-action entered into at arm’s length, the stated interest rate is presumed to be fair unless:

� No interest rate is stated, or� The stated interest rate is unreasonable, or� The stated face amount of the debt instrument is materially different from the cur-

rent cash sales price for the same or similar items or from the current market valueof the debt instrument.

In these circumstances the present value of the debt instrument is measured by the fairvalue of the property, goods, or services or by an amount that reasonably approximatesthe market value of the note.16 The interest element other than that evidenced by anystated rate of interest is the difference between the face amount of the note and thefair value of the property.

For example, assume that Scenic Development Company sold land having a cashsale price of $200,000 to Health Spa, Inc. in exchange for Health Spa’s 5-year, $293,860zero-interest-bearing note. The $200,000 cash sale price represents the present value ofthe $293,860 note discounted at 8 percent for 5 years. If the transaction is recorded byboth parties on the sale date at the face amount of the note, $293,860, Health Spa’s Land


ILLUSTRATION 14-11Schedule of NoteDiscount Amortization

SCHEDULE OF NOTE DISCOUNT AMORTIZATIONEFFECTIVE INTEREST METHOD

10% NOTE DISCOUNTED AT 12%

CarryingCash Interest Discount AmountPaid Expense Amortized of Note

Date of issue $ 9,520End of year 1 $1,000a $1,142b $142c 9,662d

End of year 2 1,000 1,159 159 9,821 End of year 3 1,000 1,179 179 10,000

$3,000 $3,480 $480

a$10,000 � 10% � $1,000 c$1,142 � $1,000 � $142b$9,520 � 12% � $1,142 d$9,520 � $142 � $9,662

16“Interest on Receivables and Payables,” op. cit., par. 12.

The discount is then amortized and interest expense is recognized annually using theeffective interest method. The 3-year discount amortization and interest expenseschedule is shown in Illustration 14-11.


account and Scenic’s sales would be overstated by $93,860, because the $93,860 repre-sents the interest for 5 years at an effective rate of 8 percent. Interest revenue to Scenicand interest expense to Health Spa for the 5-year period correspondingly would be un-derstated by $93,860.

Because the difference between the cash sale price of $200,000 and the $293,860 faceamount of the note represents interest at an effective rate of 8 percent, the transactionis recorded at the exchange date as follows.

Special Notes Payable Situations • 687

ILLUSTRATION 14-12Entries for Noncash NoteTransactions

Health Spa, Inc. Books Scenic Development Company Books

Land 200,000 Notes Receivable 293,860Discount on Notes Payable 93,860 Discount on Notes Rec. 93,860

Notes Payable 293,860 Sales 200,000

During the 5-year life of the note, Health Spa amortizes annually a portion of thediscount of $93,860 as a charge to interest expense. Scenic Development records inter-est revenue totaling $93,860 over the 5-year period by also amortizing the discount.The effective interest method is required, although other approaches to amortizationmay be used if the results obtained are not materially different from those that resultfrom the effective interest method.

Choice of Interest RateIn note transactions, the effective or real interest rate is either evident or determinableby other factors involved in the exchange, such as the fair market value of what is givenor received. But, if the fair value of the property, goods, services, or other rights is notdeterminable, and if the note has no ready market, the problem of determining thepresent value of the note is more difficult. To estimate the present value of a note undersuch circumstances, an applicable interest rate that may differ from the stated interestrate must be approximated. This process of interest-rate approximation is called im-putation, and the resulting interest rate is called an imputed interest rate.

The choice of a rate is affected by the prevailing rates for similar instruments of is-suers with similar credit ratings. It is also affected specifically by restrictive covenants,collateral, payment schedule, the existing prime interest rate, etc. Determination of theimputed interest rate is made when the note is issued; any subsequent changes in pre-vailing interest rates are ignored.

To illustrate, assume that on December 31, 2004, Wunderlich Company issued apromissory note to Brown Interiors Company for architectural services. The note hasa face value of $550,000, a due date of December 31, 2009, and bears a stated interestrate of 2 percent, payable at the end of each year. The fair value of the architecturalservices is not readily determinable, nor is the note readily marketable. On the basis ofthe credit rating of Wunderlich Company, the absence of collateral, the prime interestrate at that date, and the prevailing interest on Wunderlich’s other outstanding debt,an 8 percent interest rate is imputed as appropriate in this circumstance. The timediagram depicting both cash flows is shown as follows.

4n = 5

i = 8%

2 3 50 1

$11,000 Interest

$550,000 Principal

$11,000$11,000$11,000$11,000PVPV –– OAOA

PVPVPV

PV – OA


The present value of the note and the imputed fair value of the architectural ser-vices are determined as follows.


ILLUSTRATION 14-13Computation of ImputedFair Value and NoteDiscount

Face value of the note $550,000Present value of $550,000 due in 5 years at 8% interest payable

annually (Table 6-2); FV(PVF5,8%); ($550,000 � .68058) $374,319Present value of $11,000 interest payable annually for 5 years at 8%;

R(PVF-OA5,8%); ($11,000 � 3.99271) 43,920

Present value of the note 418,239

Discount on notes payable $131,761

The issuance of the note in payment for the architectural services is recorded asfollows.

December 31, 2004

Building (or Construction in Process) 418,239Discount on Notes Payable 131,761

Notes Payable 550,000

The 5-year amortization schedule appears below.

ILLUSTRATION 14-14Schedule of DiscountAmortization UsingImputed Interest Rate

SCHEDULE OF NOTE DISCOUNT AMORTIZATIONEFFECTIVE INTEREST METHOD

2% NOTE DISCOUNTED AT 8% (IMPUTED)

Cash Interest CarryingPaid Expense Discount Amount

Date (2%) (8%) Amortized of Note

12/31/04 $418,23912/31/05 $11,000a $ 33,459b $ 22,459c 440,698d

12/31/06 11,000 35,256 24,256 464,95412/31/07 11,000 37,196 26,196 491,15012/31/08 11,000 39,292 28,292 519,44212/31/09 11,000 41,558e 30,558 550,000

$55,000 $186,761 $131,761

a$550,000 � 2% � $11,000 d$418,239 � $22,459 � $440,698b$418,239 � 8% � $33,459 e$3 adjustment to compensate for rounding.c$33,459 � $11,000 � $22,459

Calculator Solution forthe Fair Value of Services:

N

Inputs

5

I/YR 8

PV ?

PMT 11,000

FV 550,000

418,239

Answer

Payment of the first year’s interest and amortization of the discount is recorded asfollows.

December 31, 2005

Interest Expense 33,459Discount on Notes Payable 22,459Cash 11,000

MORTGAGE NOTES PAYABLEThe most common form of long-term notes payable is a mortgage note payable. Amortgage note payable is a promissory note secured by a document called a mortgagethat pledges title to property as security for the loan. Mortgage notes payable are usedmore frequently by proprietorships and partnerships than by corporations. (Corpora-tions usually find that bond issues offer advantages in obtaining large loans.) On the


balance sheet, the liability should be reported using a title such as “Mortgage NotesPayable” or “Notes Payable—Secured,” with a brief disclosure of the property pledgedin notes to the financial statements.

The borrower usually receives cash in the face amount of the mortgage note. Inthat case, the face amount of the note is the true liability and no discount or premiumis involved. When “points” are assessed by the lender, however, the total amount paidby the borrower exceeds the face amount of the note.17 Points raise the effective inter-est rate above the rate specified in the note. A point is 1 percent of the face of the note.For example, assume that a 20-year mortgage note in the amount of $100,000 with astated interest rate of 10.75 percent is given by you to Local Savings and Loan Associ-ation as part of the financing of your new house. If Local Savings demands 4 points toclose the financing, you will receive 4 percent less than $100,000—or $96,000—but youwill be obligated to repay the entire $100,000 at the rate of $1,015 per month. Becauseyou received only $96,000, and must repay $100,000, your effective interest rate is in-creased to approximately 11.3 percent on the money you actually borrowed.

Mortgages may be payable in full at maturity or in installments over the life of theloan. If payable at maturity, the mortgage payable is shown as a long-term liability onthe balance sheet until such time as the approaching maturity date warrants showingit as a current liability. If it is payable in installments, the current installments due areshown as current liabilities, with the remainder shown as a long-term liability.

The traditional fixed-rate mortgage has been partially supplanted with alternativemortgage arrangements. Most lenders offer variable-rate mortgages (also called float-ing-rate or adjustable rate mortgages) featuring interest rates tied to changes in the fluc-tuating market rate. Generally the variable-rate lenders adjust the interest rate at either1- or 3-year intervals, pegging the adjustments to changes in the prime rate or the U.S.Treasury bond rate.

Off-Balance-Sheet Financing • 689

17Points, in mortgage financing, are analogous to the original issue discount of bonds.

R E P O R T I N G A N D A N A LY S I S O F L O N G - T E R M D E B T SECTION 3

Reporting of long-term debt is one of the most controversial areas in financial report-ing. Because long-term debt has a significant impact on the cash flows of the company,reporting requirements must be substantive and informative. One problem is that thedefinition of a liability established in Concepts Statement No. 6 and the recognition cri-teria established in Concepts Statement No. 5 are sufficiently imprecise that argumentscan still be made that certain obligations need not be reported as debt.

OFF-BALANCE-SHEET FINANCINGWhat do Krispy Kreme, Cisco, Enron, and Adelphia Communications have in com-mon? They all have been accused of using off-balance-sheet financing to minimize thereporting of debt on their balance sheets. Off-balance-sheet financing is an attempt toborrow monies in such a way that the obligations are not recorded. It has become anissue of extreme importance because many allege that Enron, in one of the largest cor-porate failures on record, hid a considerable amount of its debt off the balance sheet.As a result, any company that uses off-balance-sheet financing today is taking the riskthat investors (given their concerns about what happened at Enron) will dump theirstock, and share price will suffer. Nevertheless, a considerable amount of off-balance-sheet financing will continue to exist. As one writer noted, “The basic drives of humansare few: to get enough food, to find shelter, and to keep debt off the balance sheet.”

OBJECTIVE �Explain the reporting ofoff-balance-sheetfinancingarrangements.


Different FormsOff-balance-sheet financing can take many different forms. Here are a few examples:

� Non-Consolidated Subsidiary: Under present GAAP, a parent company does nothave to consolidate a subsidiary company that is less than 50 percent owned. Insuch cases, the parent therefore does not report the assets and liabilities of the sub-sidiary. All the parent reports on its balance sheet is the investment in the sub-sidiary. As a result, users of the financial statements may not understand that thesubsidiary has considerable debt for which the parent may ultimately be liable ifthe subsidiary runs into financial difficulty.

� Special Purpose Entity (SPE): A special purpose entity is an entity created by acompany to perform a special project. To illustrate, assume that Clarke Companyhas decided to build a new factory. In determining whether to build the new fac-tory, an important variable in the decision is that management does not want toreport on its balance sheet the borrowing used to fund the construction. It there-fore creates an SPE whose sole purpose is to build the plant (referred to as a proj-ect financing arrangement). The SPE finances and builds the plant, and then ClarkeCompany guarantees that all the products produced by the plant will be purchased,either by Clarke Company or some outside party. (Some refer to this as a take-or-pay contract). As a result, Clarke Company does not report the asset or liability onits books. It should be emphasized that the accounting rules in this area are com-plex, but a company can achieve this objective with relative ease.

� Operating Leases: Another way that companies keep debt off the balance sheet isby leasing. Instead of owning the assets, companies lease them. Again, by meetingcertain conditions, the company has to report only rent expense each period andto provide note disclosure of the transaction. It should be noted that SPEs often useleases to accomplish off-balance-sheet treatment. Accounting for lease transactionsis discussed extensively in Chapter 21.

RationaleWhy do companies engage in off-balance-sheet financing? A major reason is that manybelieve that removing debt enhances the quality of the balance sheet and permitscredit to be obtained more readily and at less cost.

Second, loan covenants often impose a limitation on the amount of debt a com-pany may have. As a result, off-balance-sheet financing is used, because these types ofcommitments might not be considered in computing the debt limitation.

Third, it is argued by some that the asset side of the balance sheet is severelyunderstated. For example, companies that use LIFO costing for inventories and de-preciate assets on an accelerated basis will often have carrying amounts for inven-tories and property, plant, and equipment that are much lower than their currentvalues. As an offset to these lower values, some managements believe that part ofthe debt does not have to be reported. In other words, if assets were reported atcurrent values, less pressure would undoubtedly exist for off-balance-sheet financ-ing arrangements.

Whether the arguments above have merit is debatable. The general idea “out ofsight, out of mind” may not be true in accounting. Many users of financial statementsindicate that they factor these off-balance-sheet financing arrangements into their com-putations when assessing debt to equity relationships. Similarly, many loan covenantsalso attempt to take these complex arrangements into account. Nevertheless, manycompanies still believe that benefits will accrue if certain obligations are not reportedon the balance sheet.

The FASB’s response to off-balance-sheet financing arrangements has been in-creased disclosure (note) requirements. In addition, the SEC, in response to the Sar-banes-Oxley Act of 2002, now requires companies in their Management Discussion and



Analysis section to provide information on (1) all contractual obligations in a tabularformat and (2) contingent liabilities and commitments in either a textual or tabular for-mat.18 The authors believe that financial reporting would be enhanced if more obliga-tions were recorded on the balance sheet instead of merely described in the notes tothe financial statements. Given the problems with companies such as Enron, Dynergy,Williams Companies, Adelphia Communications, and Calpine, our expectation is thatless off-balance-sheet financing will occur in the future.

PRESENTATION AND ANALYSIS OF LONG-TERM DEBT

Presentation of Long-Term DebtCompanies that have large amounts and numerous issues of long-term debt frequentlyreport only one amount in the balance sheet and support this with comments and sched-ules in the accompanying notes. Long-term debt that matures within one year shouldbe reported as a current liability, unless retirement is to be accomplished with otherthan current assets. If the debt is to be refinanced, converted into stock, or is to be re-tired from a bond retirement fund, it should continue to be reported as non-currentand accompanied with a note explaining the method to be used in its liquidation.19

Note disclosures generally indicate the nature of the liabilities, maturity dates, in-terest rates, call provisions, conversion privileges, restrictions imposed by the creditors,and assets designated or pledged as security. Any assets pledged as security for thedebt should be shown in the assets section of the balance sheet. The fair value of thelong-term debt should also be disclosed if it is practical to estimate fair value. Finally,disclosure is required of future payments for sinking fund requirements and maturityamounts of long-term debt during each of the next 5 years.20 The purpose of these dis-closures is to aid financial statement users in evaluating the amounts and timing offuture cash flows. An example of the type of information provided is shown on page692 for Best Buy Co.

Note that if the company has any unconditional long-term obligations (such as proj-ect financing arrangements) that are not reported in the balance sheet, extensive notedisclosure must be provided.21

Analysis of Long-Term DebtLong-term creditors and stockholders are interested in a company’s long-run solvency,particularly its ability to pay interest as it comes due and to repay the face value of thedebt at maturity. Debt to total assets and times interest earned are two ratios that pro-vide information about debt-paying ability and long-run solvency.

The debt to total assets ratio measures the percentage of the total assets providedby creditors. It is computed as shown in Illustration 14-15 by dividing total debt (bothcurrent and long-term liabilities) by total assets.

Presentation and Analysis of Long-Term Debt • 691

18It is unlikely that accounting regulators will be able to stop all types of off-balance-sheet trans-actions. Financial information is the Holy Grail of Wall Street. Developing new financial instrumentsand arrangements to sell and market to customers is not only profitable, but also adds to the pres-tige of the investment firms that create them. Thus, new financial products will continue to appearthat will test the ability of regulators to develop appropriate accounting standards for them.

19“Balance Sheet Classification of Short-Term Obligations Expected to Be Refinanced,” FASBStatement of Financial Accounting Standards No. 6 (Stamford, Conn.: FASB, 1975), par. 15. See also“Disclosure of Information about Capital Structure,” FASB Statement of Financial Accounting Stan-dards No. 129 (Norwalk, Conn.: FASB, 1997), par. 4.

20“Disclosure of Long-Term Obligations,” Statement of Financial Accounting Standards No. 47(Stamford, Conn.: FASB, 1981), par. 10.

21Ibid., par. 7.

OBJECTIVE Indicate how long-termdebt is presented andanalyzed.


The higher the percentage of debt to total assets, the greater the risk that the companymay be unable to meet its maturing obligations.


Debt to total assets �Total debt��Total assets

ILLUSTRATION 14-15Computation of Debt toTotal Assets Ratio

Best Buy Co.(dollars in thousands)

March 3, Feb. 26,2001 2000

Total current assets $2,928,663 $2,238,460

Current liabilitiesAccounts payable $1,772,722 $1,313,940Accrued compensation and related expenses 154,159 102,065Accrued liabilities 545,590 287,888Accrued income taxes 127,287 65,366Current portion of long-term debt 114,940 15,790

Total current liabilities 2,714,698 1,785,049

Long-term liabilities 121,952 99,448

Long-term debt (Note 3.) 181,009 14,860

Note 3. Debt (in part)March 3, Feb. 26,

2001 2000

Senior subordinated notes, face amount $109,500, unsecured, due 2003, interest rate 9.0%, effective rate 8.9% $ 110,471 $ —

Senior subordinated notes, face amount $150,000, unsecured, due 2008, interest rate 9.9%, effective rate 8.5% 160,574 —

Mortgage and other debt, interest rates ranging from 5.3% to 9.4% 24,904 30,650

Total debt 295,949 30,650Less current portion (114,940) (15,790)

Long-term debt $ 181,009 $ 14,860

The mortgage and other debt are secured by certain property and equipment with a net book value of$43,500 and $35,600 at March 3, 2001, and February 26, 2000, respectively.During fiscal 2001, 2000, and 1999, interest paid totaled $7,000, $5,300, and $23,800, respectively.During fiscal 2001, 2000, and 1999, interest expense totaled $6,900, $5,100, and $19,400, respectively,and is included in net interest income. The fair value of long-term debt approximates the carrying value.The future maturities of long-term debt consist of the following:

Fiscal Year

2002 $114,9402003 2,0362004 8952005 7452006 810Thereafter 176,523

$295,949

ILLUSTRATION 14-16Long-Term DebtDisclosure

The times interest earned ratio indicates the company’s ability to meet interestpayments as they come due. It is computed by dividing income before interest expenseand income taxes by interest expense, as shown in Illustration 14-17.


To illustrate these ratios, we will use data from Best Buy’s 2001 Annual Report,which disclosed total liabilities of $3,018 million, total assets of $4,840 million, interestexpense of $6.9 million, income taxes of $246 million, and net income of $396 million.Best Buy’s debt to total assets and times interest earned ratios are computed as follows.

Summary of Learning Objectives • 693

ILLUSTRATION 14-17Computation of TimesInterest Earned Ratio

Times interest earned � Income before income taxes and interest expense��

Interest expense

Even though Best Buy has a relatively high debt to total assets percentage of 62.4, itsinterest coverage of 94 times indicates it can easily meet its interest payments as theycome due.

ILLUSTRATION 14-18Computation of Long-Term Debt Ratios for BestBuy

Debt to total assets � � 62.4%

Times interest earned � � 94 times($396 � $6.9 � $246)��

$6.9

$3,018�$4,840

KEY TERMS

bearer (coupon) bonds, 672

bond discount, 673bond indenture, 671bond premium, 673callable bonds, 671carrying value, 677commodity-backed

bonds, 672convertible bonds, 671debenture bonds, 671debt to total assets

ratio, 691deep discount (zero-

interest) debenturebonds, 672

effective interest method, 676

effective yield, or marketrate, 673

extinguishment of debt, 681

face, par, principal ormaturity value, 673

imputed interest rate, 687income bonds, 672long-term debt, 670long-term notes

payable, 683mortgage notes

payable, 688

SUMMARY OF LEARNING OBJECTIVES

� Describe the formal procedures associated with issuing long-term debt. Incurringlong-term debt is often a formal procedure. The bylaws of corporations usually requireapproval by the board of directors and the stockholders before bonds can be issuedor other long-term debt arrangements can be contracted. Generally, long-term debthas various covenants or restrictions. The covenants and other terms of the agreementbetween the borrower and the lender are stated in the bond indenture or noteagreement.

� Identify various types of bond issues. Types of bond issues are: (1) Secured and un-secured bonds. (2) Term, serial, and callable bonds. (3) Convertible, commodity-backed, anddeep discount bonds. (4) Registered and bearer (coupon) bonds. (5) Income and revenue bonds.The variety in the types of bonds is a result of attempts to attract capital from differ-ent investors and risk takers and to satisfy the cash flow needs of the issuers.

� Describe the accounting valuation for bonds at date of issuance. The investment com-munity values a bond at the present value of its future cash flows, which consist ofinterest and principal. The rate used to compute the present value of these cash flowsis the interest rate that provides an acceptable return on an investment commensu-rate with the issuer’s risk characteristics. The interest rate written in the terms of thebond indenture and ordinarily appearing on the bond certificate is the stated, coupon,or nominal rate. This rate, which is set by the issuer of the bonds, is expressed as apercentage of the face value, also called the par value, principal amount, or maturityvalue, of the bonds. If the rate employed by the buyers differs from the stated rate,the present value of the bonds computed by the buyers will differ from the face valueof the bonds. The difference between the face value and the present value of the bondsis either a discount or premium.

� Apply the methods of bond discount and premium amortization. The discount (pre-mium) is amortized and charged (credited) to interest expense over the period of timethat the bonds are outstanding. Bond interest expense is increased by amortization ofa discount and decreased by amortization of a premium. The profession’s preferredprocedure for amortization of a discount or premium is the effective interest method.Under the effective interest method, (1) bond interest expense is computed by multi-plying the carrying value of the bonds at the beginning of the period by the effective


interest rate, and (2) the bond discount or premium amortization is then determinedby comparing the bond interest expense with the interest to be paid.

� Describe the accounting procedures for the extinguishment of debt. At the time ofreacquisition, the unamortized premium or discount and any costs of issue applica-ble to the debt must be amortized up to the reacquisition date. The amount paid onextinguishment or redemption before maturity, including any call premium andexpense of reacquisition, is the reacquisition price. On any specified date, the net car-rying amount of the debt is the amount payable at maturity, adjusted for unamor-tized premium or discount and cost of issuance. Any excess of the net carrying amountover the reacquisition price is a gain from extinguishment. The excess of the reacqui-sition price over the net carrying amount is a loss from extinguishment. Gains andlosses on extinguishments are recognized currently in income.

� Explain the accounting procedures for long-term notes payable. Accounting proce-dures for notes and bonds are quite similar. Like a bond, a note is valued at the pres-ent value of its future interest and principal cash flows, with any discount or premiumbeing similarly amortized over the life of the note. Whenever the face amount of thenote does not reasonably represent the present value of the consideration given orreceived in the exchange, the entire arrangement must be evaluated to properly recordthe exchange and the subsequent interest.

� Explain the reporting of off-balance-sheet financing arrangements. Off-balance-sheetfinancing is an attempt to borrow funds in such a way that the obligations are notrecorded. Examples of off-balance-sheet arrangements are (1) non-consolidated sub-sidiaries, (2) special purpose entities, and (3) operating leases.

Indicate how long-term debt is presented and analyzed. Companies that have largeamounts and numerous issues of long-term debt frequently report only one amountin the balance sheet and support this with comments and schedules in the accompa-nying notes. Any assets pledged as security for the debt should be shown in the as-sets section of the balance sheet. Long-term debt that matures within one year shouldbe reported as a current liability, unless retirement is to be accomplished with otherthan current assets. If the debt is to be refinanced, converted into stock, or is to be re-tired from a bond retirement fund, it should continue to be reported as non-currentand accompanied with a note explaining the method to be used in its liquidation. Dis-closure is required of future payments for sinking fund requirements and maturityamounts of long-term debt during each of the next 5 years. Debt to total assets andtimes interest earned are two ratios that provide information about debt-paying abil-ity and long-run solvency.


off-balance-sheetfinancing, 689

project financingarrangement, 690

refunding, 682registered bonds, 672revenue bonds, 672secured bonds, 671serial bonds, 671special purpose

entity, 690stated, coupon, or

nominal rate, 673straight-line method, 675take-or-pay contract, 690term bonds, 671times interest earned

ratio, 692treasury bonds, 681zero-interest debenture

bonds, 672

Accounting for Troubled Debt

During periods of depressed economic conditions or other financial hardship, somedebtors have difficulty meeting their financial obligations. For example, owing to ris-ing interest rates and corporate mismanagement, the savings and loan industry expe-rienced a decade of financial crises. The banking industry also faced credit concerns:During the late 1980s bad energy loans and the rescheduling of loans between “less

A P P E N D I X14AA P P E N D I X14A


developed countries,” such as Argentina, Brazil, and Mexico, and major U.S. bankscreated considerable uncertainty about the soundness of our banking system. Electricutilities with large nuclear plant construction programs suffered from the financialstrains of illiquidity. More recently, companies such as Xerox, Kmart, and Polaroid hadto restructure their debts or in some other way be bailed out of negative cash flow sit-uations when the economy, technology, competition, or a combination thereof, turnedagainst them.

ACCOUNTING ISSUESThe major accounting issues related to troubled debt situations involve recognition andmeasurement. In other words, when should a loss be recognized and at what amount?

To illustrate the major issue related to recognition, assume that Metro Bank has a$10,000,000, 5-year, 10 percent loan to Brazil, with interest receivable annually. At theend of the third year, Metro Bank has determined that it probably will be able to collectonly $7,000,000 of this loan at maturity. Should it wait until the loan becomes uncol-lectible, or should it record a loss immediately? The general recognition principle is this:Losses should be recorded immediately if it is probable that the loss will occur.

Assuming that Metro Bank decides to record a loss, at what amount should theloss be recorded? Three alternatives are:

� Aggregate Cash Flows. Some argue that a loss should not be recorded unless theaggregate cash flows from the loan are less than its carrying amount. In the MetroBank example, the aggregate cash flows expected are $7,000,000 of principal and$2,000,000 of interest ($10,000,000 � 10% � 2), for a total of $9,000,000. Thus, a lossof only $1,000,000 ($10,000,000 � $9,000,000) would be reported.

Advocates of this position argue that Metro Bank will recover $9,000,000 of the$10,000,000, and therefore its loss is only $1,000,000. Others disagree, noting thatthis approach ignores present values. That is, the present value of the future cashflows is much less than $9,000,000, and therefore the loss is much greater than$1,000,000.

� Present Value—Historical Effective Rate. Those who argue for the use of presentvalue, however, disagree about the interest rate to use to discount the expected fu-ture cash flows. The two rates discussed are the historical (original) effective rateand the market rate at the time the loan is recognized as troubled.

Those who favor the historical effective rate believe that losses should reflectonly a deterioration in credit quality. When the historical effective loan rate is used,the value of the investment will change only if some of the legally contracted cashflows are reduced. A loss in this case is recognized because the expected future cashflows have changed. Interest rate changes caused by current economic events thataffect the fair value of the loan are ignored.

� Present Value—Market Rate. Others believe that expected future cash flows of atroubled loan should be discounted at market interest rates, which reflect currenteconomic events and conditions that are commensurate with the risks involved.The historical effective interest rate reflects the risk characteristics of the loan at thetime it was originated or acquired, but not at the time it is troubled. In short, pro-ponents of the market rate believe that a fair value measure should be used.

This appendix addresses issues concerning the accounting by debtors and credi-tors for troubled debt. Two different types of situations result with troubled debt:

� Impairments.� Restructurings:

a. Settlements.b. Modification of terms.

In a troubled debt situation, the creditor usually first recognizes a loss on impair-ment. Subsequently either the terms of the loan are modified, or the loan is settled on

Accounting Issues • 695

OBJECTIVE Distinguish among andaccount for: (1) a losson loan impairment,(2) a troubled debtrestructuring thatresults in thesettlement of a debt,and (3) a troubled debtrestructuring thatresults in acontinuation of debtwith modification ofterms.


terms unfavorable to the creditor. In unusual cases, the creditor forces the debtor intobankruptcy in order to ensure the highest possible collection on the loan. Illustration14A-1 shows this continuum.


ILLUSTRATION 14A-1Usual Progression inTroubled Debt Situations

BankruptcyLoanImpairment

Modification ofTerms

LoanOrigination

IMPAIRMENTSA loan1 is considered impaired when, based on current information and events, it isprobable2 that the creditor will be unable to collect all amounts due (both principaland interest) according to the contractual terms of the loan. Creditors should applytheir normal review procedures in making the judgment as to the probability of col-lection.3 If a loan is considered impaired, the loss due to the impairment should bemeasured as the difference between the investment in the loan (generally the principalplus accrued interest) and the expected future cash flows discounted at the loan’s his-torical effective interest rate.4 In estimating future cash flows the creditor should em-ploy all reasonable and supportable assumptions and projections.5

Illustration of Loss on ImpairmentOn December 31, 2003, Prospect Inc. issued a $500,000, 5-year, zero-interest-bearingnote to Community Bank. The note was issued to yield 10 percent annual interest. Asa result, Prospect received and Community Bank paid $310,460 ($500,000 � .62092) onDecember 31, 2003.6 A time diagram at the top of the next page illustrates the factorsinvolved.

1FASB Statement No. 114, “Accounting by Creditors for Impairment of a Loan” (Norwalk,Conn.: FASB, May 1993), defines a loan as “a contractual right to receive money on demand oron fixed and determinable dates that is recognized as an asset in the creditor’s statement offinancial position.” For example, accounts receivable with terms exceeding one year are con-sidered loans.

2Recall the definitions of probable, reasonably possible, and remote with respect to contin-gencies, as defined in FASB Statement No. 5.

3Normal review procedures include examination of “watch lists,” review of regulatory re-ports of examination, and examination of management reports of total loan amounts by borrower.

4The creditor may also, for the sake of expediency, use the market price of the loan (if sucha price is available) or the fair value of collateral if it is a collateralized loan. FASB StatementNo. 114, par. 13.

5FASB Statement No. 114, par. 15.6Present value of $500,000 due in 5 years at 10%, annual compounding (Table 6-2) equals

$500,000 � .62092.


The entries to record this transaction on the books of Community Bank (creditor) andProspect Inc. (debtor) are as follows.

Impairments • 697

12/31/07Number of Periods

n = 5

Interest Ratei = 10%

12/31/05 12/31/06 12/31/0812/31/03 12/31/04

FutureValue

$500,000

PresentValue

$310,460

December 31, 2003

Community Bank (Creditor) Prospect Inc. (Debtor)

Notes Receivable 500,000 Cash 310,460Discount on Notes Discount on Notes

Receivable 189,540 Payable 189,540Cash 310,460 Notes Payable 500,000

ILLUSTRATION 14A-2Creditor and DebtorEntries to Record Note

Assuming that Community Bank and Prospect Inc. use the effective interest methodto amortize discounts, Illustration 14A-3 shows the amortization of the discount andthe increase in the carrying amount of the note over the life of the note.

COMMUNITY BANK

Cash Interest CarryingReceived Revenue Discount Amount of

Date (0%) (10%) Amortized Note

12/31/03 $310,46012/31/04 $0 $ 31,046a $ 31,046 341,506b

12/31/05 0 34,151 34,151 375,65712/31/06 0 37,566 37,566 413,22312/31/07 0 41,322 41,322 454,54512/31/08 0 45,455 45,455 500,000

Total $0 $189,540 $189,540

a$31,046 � $310,460 � .10b$341,506 � $310,460 � $31,046

ILLUSTRATION 14A-3Schedule of Interest andDiscount Amortization(Before Impairment)

Unfortunately, during 2005 Prospect’s business deteriorated due to increased com-petition and a faltering regional economy. After reviewing all available evidence atDecember 31, 2005, Community Bank determined that it was probable that Prospectwould pay back only $300,000 of the principal at maturity. As a result, CommunityBank decided that the loan was impaired and that a loss should be recorded immedi-ately.

To determine the loss, the first step is to compute the present value of the expectedcash flows discounted at the historical effective rate of interest. This amount is $225,396.The time diagram on the next page highlights the factors involved in this computation.



The loss due to impairment is equal to the difference between the present value ofthe expected future cash flows and the recorded carrying amount of the investment inthe loan. The calculation of the loss is shown in Illustration 14A-4.

FutureValue

$300,000

12/31/05 12/31/06 12/31/08

Interest Ratei = 10%

Number of Periodsn = 3

PresentValue

$225,396

12/31/07

ILLUSTRATION 14A-4Computation of Loss Dueto Impairment

Carrying amount of investment (12/31/05)—Illustration 14A-3 $375,657Less: Present value of $300,000 due in 3 years at 10% interest

compounded annually (Table 6-2); FV(PVF3,10%);($300,000 � .75132) 225,396

Loss due to impairment $150,261

The loss due to the impairment is $150,261, not $200,000 ($500,000 � $300,000). Thereason is that the loss is measured at a present value amount, not an undiscountedamount, at the time the loss is recorded.

The entry to record the loss is as follows.

December 31, 2005

Community Bank (Creditor) Prospect Inc. (Debtor)

Bad Debt Expense 150,261 No entryAllowance for Doubtful Accounts 150,261

ILLUSTRATION 14A-5Creditor and DebtorEntries to Record Loss onNote

Community Bank (creditor) debits Bad Debt Expense for the expected loss. At the sametime, it reduces the overall value of its loan receivable by crediting Allowance for Doubt-ful Accounts.7 On the other hand, Prospect Inc. (debtor) makes no entry because it stilllegally owes $500,000.8

7In the event that the loan is written off, the loss is charged against the allowance. In sub-sequent periods, if the estimated expected cash flows are revised based on new information, theallowance account and bad debt account are adjusted (either increased or decreased dependingwhether conditions improved or worsened) in the same fashion as the original impairment. Theterms “loss” and “bad debt expense” are used interchangeably throughout this discussion. Lossesrelated to receivables transactions should be charged to Bad Debt Expense or the relatedAllowance for Doubtful Accounts because these are the accounts used to recognize changes invalues affecting receivables.

8Many alternatives are permitted to recognize income in subsequent periods. See FASBStatement No. 118, “Accounting by Creditors for Impairment of a Loan—Income Recognition andDisclosures” (Norwalk, Conn.: FASB, October 1994) for appropriate methods.


Troubled Debt Restructurings • 699

TROUBLED DEBT RESTRUCTURINGSA troubled debt restructuring occurs when a creditor “for economic or legal reasonsrelated to the debtor’s financial difficulties grants a concession to the debtor that itwould not otherwise consider.”9 Thus a troubled debt restructuring does not apply tomodifications of a debt obligation that reflect general economic conditions that dictatea reduction in interest rates. Nor does it apply to the refunding of an old debt withnew debt having an effective interest rate approximately equal to that of similar debtissued by nontroubled debtors.

A troubled debt restructuring 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.

Settlement of DebtA transfer of noncash assets (real estate, receivables, or other assets) or the issuance ofthe debtor’s stock can be used to settle a debt obligation in a troubled debt restructur-ing. In these situations, the noncash assets or equity interest given should be ac-counted for at their fair market value. The debtor is required to determine the excessof the carrying amount of the payable over the fair value of the assets or equity trans-ferred (gain). Likewise, the creditor is required to determine the excess of the receiv-able over the fair value of those same assets or equity interests transferred (loss). Thedebtor recognizes a gain equal to the amount of the excess, and the creditor normallywould charge the excess (loss) against Allowance for Doubtful Accounts. In addition,the debtor recognizes a gain or loss on disposition of assets to the extent that the fairvalue of those assets differs from their carrying amount (book value).

Transfer of AssetsAssume that American City Bank has loaned $20,000,000 to Union Mortgage Com-pany. Union Mortgage in turn has invested these monies in residential apartment buildings, but because of low occupancy rates it cannot meet its loan obligations. Ameri-can City Bank agrees to accept from Union Mortgage real estate with a fair marketvalue of $16,000,000 in full settlement of the $20,000,000 loan obligation. The real es-tate has a recorded value of $21,000,000 on the books of Union Mortgage Company.The entry to record this transaction on the books of American City Bank (creditor) isas follows.

Real Estate 16,000,000Allowance for Doubtful Accounts 4,000,000

Note Receivable from Union Mortgage Company 20,000,000

The real estate is recorded at fair market value, and a charge is made to the Allowancefor Doubtful Accounts to reflect the bad debt write-off.

The entry to record this transaction on the books of Union Mortgage Company(debtor) is as follows.

Note Payable to American City Bank 20,000,000Loss on Disposition of Real Estate 5,000,000

Real Estate 21,000,000Gain on Restructuring of Debt 4,000,000

Union Mortgage Company has a loss on the disposition of real estate in the amountof $5,000,000 (the difference between the $21,000,000 book value and the $16,000,000fair market value), which should be shown as an ordinary loss on the income state-ment. In addition, it has a gain on restructuring of debt of $4,000,000 (the difference

9“Accounting by Debtors and Creditors for Troubled Debt Restructurings,” FASB StatementNo. 15 (Norwalk, Conn.: FASB, June, 1977), par. 1.


between the $20,000,000 carrying amount of the note payable and the $16,000,000 fairmarket value of the real estate).

Granting of Equity InterestAssume that American City Bank had agreed to accept from Union Mortgage Com-pany 320,000 shares of Union’s common stock ($10 par) that has a fair market value of$16,000,000 in full settlement of the $20,000,000 loan obligation. The entry to record thistransaction on the books of American City Bank (creditor) is as follows.

Investment 16,000,000Allowance for Doubtful Accounts 4,000,000

Note Receivable from Union Mortgage Company 20,000,000

The stock received by American City Bank is recorded as an investment at the fair mar-ket value at the date of restructure.

The entry to record this transaction on the books of Union Mortgage Company(debtor) is as follows.

Note Payable to American City Bank 20,000,000Common Stock 3,200,000Additional Paid-in Capital 12,800,000Gain on Restructuring of Debt 4,000,000

The stock issued by Union Mortgage Company is recorded in the normal manner withthe difference between the par value and the fair value of the stock recorded as addi-tional paid-in capital.

Modification of TermsIn some cases, a debtor will have serious short-run cash flow problems that lead it torequest 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.

Under FASB Statement No. 114, the creditor’s loss is based upon cash flows dis-counted at the historical effective rate of the loan. The FASB concluded that, “becauseloans are recorded originally at discounted amounts, the ongoing assessment for im-pairment should be made in a similar manner.”10 The debtor’s gain is calculated basedupon undiscounted amounts, as required by the previous standard. As a consequence,the gain recorded by the debtor will not equal the loss recorded by the creditor undermany circumstances.11

Two illustrations demonstrate the accounting for a troubled debt restructuring bydebtors and creditors:

� The debtor does not record a gain.� The debtor records a gain.

In both instances the creditor has a loss.


10FASB Statement No. 114, par. 42.11In response to concerns expressed about this nonsymmetric treatment, the FASB stated that

Statement No. 114 does not address debtor accounting because the FASB was concerned thatexpansion of the scope of the statement would delay its issuance.



Illustration 1—No Gain for DebtorThis illustration demonstrates a restructuring in which no gain is recorded by the debtor.12

On December 31, 2003, Morgan National Bank enters into a debt restructuring agreementwith Resorts Development Company, which is experiencing financial difficulties. Thebank 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, 2003, to December 31, 2007; and� Reducing the interest rate from 12% to 8%.

Debtor Calculations. The total future cash flow after restructuring of $11,880,000($9,000,000 of principal plus $2,880,000 of interest payments13) exceeds the total pre-restructuring carrying amount of the debt of $10,500,000. Consequently, no gain isrecorded, and no adjustment is made by the debtor to the carrying amount of thepayable. As a result, no entry is made by Resorts Development Co. (debtor) at the dateof restructuring.

A new effective interest rate must be computed by the debtor in order to recordinterest expense in future periods. The new effective interest rate equates the presentvalue of the future cash flows specified by the new terms with the pre-restructuringcarrying amount of the debt. In this case, the new rate is computed by relating the pre-restructure carrying amount ($10,500,000) to the total future cash flow ($11,880,000).The rate necessary to discount the total future cash flow ($11,880,000) to a present valueequal to the remaining balance ($10,500,000) is 3.46613 percent.14

On the basis of the effective rate of 3.46613 percent, the schedule shown in Illus-tration 14A-6 is prepared.

12Note that the examples given for restructuring assume no previous entries were made bythe creditor for impairment. In actuality it is likely that, in accordance with Statement No. 114,the creditor would have already made an entry when the loan initially became impaired, andrestructuring would simply require an adjustment of the initial estimated bad debt by the cred-itor. Recall, however, that the debtor makes no entry upon impairment.

13Total interest payments are: $9,000,000 � .08 � 4 years � $2,880,000.14An accurate interest rate i can be found by using the formulas given at the tops of Tables

6-2 and 6-4 to set up the following equation.

$10,500,000 � � $9,000,000 � � $720,000

(from Table 6-2) (from Table 6-4)

Solving algebraically for i, we find that i � 3.46613%.

1 � �(1 �

1i)4�

��i

1�(1 � i)4

RESORTS DEVELOPMENT CO. (DEBTOR)

Cash Interest Reduction of CarryingPaid Expense Carrying Amount of

Date (8%) (3.46613%) Amount Note

12/31/03 $10,500,00012/31/04 $ 720,000a $ 363,944b $ 356,056c 10,143,94412/31/05 720,000 351,602 368,398 9,775,54612/31/06 720,000 338,833 381,167 9,394,37912/31/07 720,000 325,621 394,379 9,000,000

$2,880,000 $1,380,000 $1,500,000

a$720,000 � $9,000,000 � .08b$363,944 � $10,500,000 � 3.46613%c$356,056 � $720,000 � $363,944

ILLUSTRATION 14A-6Schedule ShowingReduction of CarryingAmount of Note

Calculator Solution forInterest Rate

N

Inputs

4

I/YR ?

PV 10,500,000

PMT 720,000

FV 9,000,000

3.466

Answer


Thus, on December 31, 2004 (date of first interest payment after restructure), thedebtor makes the following entry.

December 31, 2004

Notes Payable 356,056Interest Expense 363,944

Cash 720,000

A similar entry (except for different amounts for debits to Notes Payable and In-terest Expense) is made each year until maturity. At maturity, the following entry ismade.

December 31, 2007

Notes Payable 9,000,000Cash 9,000,000

Creditor Calculations. Morgan National Bank (creditor) is required to calculate its lossbased upon the expected future cash flows discounted at the historical effective rate ofthe loan. This loss is calculated as follows.


Pre-restructure carrying amount $10,500,000Present value of restructured cash flows:Present value of $9,000,000 due in 4 years

at 12%, interest payable annually (Table 6-2);FV(PVF4,12%); ($9,000,000 � .63552) $5,719,680

Present value of $720,000 interest payable annually for 4years at 12% (Table 6-4); R(PVF-OA4,12%);($720,000 � 3.03735) 2,186,892

Present value of restructured cash flows 7,906,572

Loss on restructuring $ 2,593,428

ILLUSTRATION 14A-7Computation of Loss toCreditor on Restructuring

As a result, Morgan National Bank records a bad debt expense as follows (assumingno allowance balance has been established from recognition of an impairment).

Bad Debt Expense 2,593,428Allowance for Doubtful Accounts 2,593,428

In subsequent periods, interest revenue is reported based on the historical effectiverate. Illustration 14A-8 provides the following interest and amortization information.

MORGAN NATIONAL BANK (CREDITOR)

Cash Interest Increase of CarryingReceived Revenue Carrying Amount of

Date (8%) (12%) Amount Note

12/31/03 $7,906,57212/31/04 $ 720,000a $ 948,789b $ 228,789c 8,135,36112/31/05 720,000 976,243 256,243 8,391,60412/31/06 720,000 1,006,992 286,992 8,678,59612/31/07 720,000 1,041,404d 321,404d 9,000,000

Total $2,880,000 $3,973,428 $1,093,428

a$720,000 � $9,000,000 � .08b$948,789 � $7,906,572 � .12c$228,789 � $948,789 � $720,000d$28 adjustment to compensate for rounding.

ILLUSTRATION 14A-8Schedule of Interest andAmortization after DebtRestructuring


On December 31, 2004, Morgan National Bank would make the following entry.

December 31, 2004

Cash 720,000Allowance for Doubtful Accounts 228,789

Interest Revenue 948,789

A similar entry (except for different amounts debited to Allowance for DoubtfulAccounts and credited to Interest Revenue) is made each year until maturity. At ma-turity, the following entry is made.

December 31, 2007

Cash 9,000,000Allowance for Doubtful Accounts 1,500,000

Notes Receivable 10,500,000

Illustration 2—Gain for DebtorIf the pre-restructure carrying amount exceeds the total future cash flows as a result ofa modification of the terms, the debtor records a gain. To illustrate, assume the facts inthe previous example except that Morgan National Bank reduced the principal to$7,000,000 (and extended the maturity date to December 31, 2007, and reduced the in-terest from 12 percent to 8 percent). The total future cash flow is now $9,240,000($7,000,000 of principal plus $2,240,000 of interest15), which is $1,260,000 less than thepre-restructure carrying amount of $10,500,000. Under these circumstances, ResortsDevelopment Company (debtor) would reduce the carrying amount of its payable$1,260,000 and record a gain of $1,260,000. On the other hand, Morgan National Bank(creditor) would debit its Bad Debt Expense for $4,350,444. This computation is shownin Illustration 14A-9.


15Total interest payments are: $7,000,000 � .08 � 4 years � $2,240,000.

ILLUSTRATION 14A-9Computation of Loss toCreditor on Restructuring

Pre-restructure carrying amount $10,500,000Present value of restructured cash flows:Present value of $7,000,000 due in 4 years at 12%,

interest payable annually (Table 6-2);FV(PVF4,12%); ($7,000,000 � .63552) $4,448,640

Present value of $560,000 interest payable annually for 4 years at 12% (Table 6-4);R(PVF-OA4,12%); ($560,000 � 3.03735) 1,700,916 6,149,556

Creditor’s loss on restructuring $ 4,350,444

Entries to record the gain and loss on the debtor’s and creditor’s books at the date ofrestructure, December 31, 2003, are shown in Illustration 14A-10.

ILLUSTRATION 14A-10Debtor and CreditorEntries to Record Gainand Loss on Note

December 31, 2003 (date of restructure)

Resorts Development Co. (Debtor) Morgan National Bank (Creditor)

Notes Payable 1,260,000 Bad Debt Expense 4,350,444Gain on Restructuring of Allowance for Doubtful Accounts 4,350,444

Debt 1,260,000


For Resorts Development (debtor), because the new carrying value of the note($10,500,000 � $1,260,000 � $9,240,000) equals the sum of the undiscounted cash flows($9,240,000), the imputed interest rate is 0 percent. Consequently, all of the future cashflows reduce the principal balance, and no interest expense is recognized. For MorganNational the interest revenue would be reported in the same fashion as the previousexample—that is, using the historical effective interest rate applied toward the newlydiscounted value of the note. Interest computations are shown in Illustration 14A-11.


MORGAN NATIONAL BANK (CREDITOR)

Cash Interest Increase in CarryingReceived Revenue Carrying Amount of

Date (8%) (12%) Amount Note

12/31/03 $6,149,55612/31/04 $ 560,000a $ 737,947b $177,947c 6,327,50312/31/05 560,000 759,300 199,300 6,526,80312/31/06 560,000 783,216 223,216 6,750,01912/31/07 560,000 809,981d 249,981d 7,000,000

Total $2,240,000 $3,090,444 $850,444

a$560,000 � $7,000,000 � .08b$737,947 � $6,149,556 � .12c$177,947 � $737,947 � $560,000d$21 adjustment to compensate for rounding.

ILLUSTRATION 14A-11Schedule of Interest andAmortization after DebtRestructuring

The following journal entries illustrate the accounting by debtor and creditor for peri-odic interest payments and final principal payment.

Resorts Development Co. (Debtor) Morgan National Bank (Creditor)

December 31, 2004 (date of first interest payment following restructure)

Notes Payable 560,000 Cash 560,000Cash 560,000 Allowance for Doubtful Accounts 177,947

Interest Revenue 737,947

December 31, 2005, 2006, and 2007 (dates of 2nd, 3rd, and last interest payments)

(Debit and credit same accounts as 12/31/04using applicable amounts from appropriate amortization schedules.)

December 31, 2007 (date of principal payment)

Notes Payable 7,000,000 Cash 7,000,000Cash 7,000,000 Allowance for Doubtful Accounts 3,500,000

Notes Receivable 10,500,000

ILLUSTRATION 14A-12Debtor and CreditorEntries to Record PeriodicInterest and FinalPrincipal Payments

KEY TERMS

impairment, 696troubled debt

restructuring, 699

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 14A

Distinguish among and account for: (1) a loss on loan impairment, (2) a troubled debtrestructuring that results in the settlement of a debt, and (3) a troubled debt restructuringthat results in a continuation of debt with modification of terms. An impairment loan lossis based on the difference between the present value of the future cash flows and thecarrying amount of the note. There are two types of settlement of debt restructurings:(1) transfer of noncash assets, and (2) granting of equity interest. For accountingpurposes there are also two types of restructurings with continuation of debt withmodified terms: (1) the carrying amount of debt is less than the future cash flows, and(2) the carrying amount of debt is greater than the total future cash flows.


QUESTIONS

Questions • 705

1. (a) From what sources might a corporation obtain fundsthrough long-term debt? (b) What is a bond indenture?What does it contain? (c) What is a mortgage?

2. Differentiate between term bonds, mortgage bonds, col-lateral trust bonds, debenture bonds, income bonds,callable bonds, registered bonds, bearer or couponbonds, convertible bonds, commodity-backed bonds,and deep discount bonds.

3. Distinguish between the following interest rates forbonds payable:

(a) yield rate (d) market rate

(b) nominal rate (e) effective rate

(c) stated rate

4. Distinguish between the following values relative tobonds payable:

(a) maturity value (c) market value

(b) face value (d) par value

5. Under what conditions of bond issuance does a discounton bonds payable arise? Under what conditions of bondissuance does a premium on bonds payable arise?

6. How should discount on bonds payable be reported onthe financial statements? Premium on bonds payable?

7. What are the two methods of amortizing discount andpremium on bonds payable? Explain each.

8. Zeno Company sells its bonds at a premium and appliesthe effective interest method in amortizing the premium.Will the annual interest expense increase or decrease overthe life of the bonds? Explain.

9. How should the costs of issuing bonds be accounted forand classified in the financial statements?

10. Where should treasury bonds be shown on the balancesheet? Should treasury bonds be carried at par or at reac-quisition cost?

11. What is the “call” feature of a bond issue? How does thecall feature affect the amortization of bond premium ordiscount?

12. Why would a company wish to reduce its bond indebt-edness before its bonds reach maturity? Indicate how thiscan be done and the correct accounting treatment forsuch a transaction.

13. How are gains and losses from extinguishment of a debtclassified in the income statement? What disclosures arerequired of such transactions?

14. What is done to record properly a transaction involvingthe issuance of a non-interest-bearing long-term note inexchange for property?

15. How is the present value of a non-interest-bearing notecomputed?

16. When is the stated interest rate of a debt instrument pre-sumed to be fair?

17. What are the considerations in imputing an appropriateinterest rate?

18. Differentiate between a fixed-rate mortgage and avariable-rate mortgage.

19. What disclosures are required relative to long-term debtand sinking fund requirements?

20. What is off-balance-sheet financing? Why might a com-pany be interested in using off-balance-sheet financing?

21. What are some forms of off-balance-sheet financing?

22. What are take-or-pay contracts and through-put con-tracts?

*23. What are three measurement bases that might be usedto value troubled debt? What are the advantages of eachmethod?

*24. What are the general rules for measuring and recogniz-ing gain or loss by both the debtor and the creditor inan impairment?

*25. What are the general rules for measuring gain or loss byboth creditor and debtor in a troubled debt restructur-ing involving a settlement?

*26. (a) In a troubled debt situation, why might the creditorgrant concessions to the debtor?

(b) What type of concessions might a creditor grant thedebtor in a troubled debt situation?

(c) What is meant by “impairment” of a loan? Underwhat circumstances should a creditor or debtor rec-ognize an impaired loan?

*27. What are the general rules for measuring and recogniz-ing gain or loss by both the debtor and the creditor in atroubled debt restructuring involving a modification ofterms?

*28. What is meant by “accounting symmetry” between theentries recorded by the debtor and creditor in a troubleddebt restructuring involving a modification of terms? Inwhat ways is the accounting for troubled debt restruc-turings and impairments non-symmetrical?

*29. Under what circumstances would a transaction berecorded as a troubled debt restructuring by only one ofthe two parties to the transaction?

Note: All asterisked Questions, Brief Exercises, Exercises, and Problems relate to material con-tained in the appendix to the chapter.


BRIEF EXERCISESBE14-1 Ghostbusters Corporation issues $300,000 of 9% bonds, due in 10 years, with interest payablesemiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of thebonds.

BE14-2 The Goofy Company issued $200,000 of 10% bonds on January 1, 2005. The bonds are due Jan-uary 1, 2010, with interest payable each July 1 and January 1. The bonds are issued at face value. PrepareGoofy’s journal entries for (a) the January issuance, (b) the July 1 interest payment, and (c) the December31 adjusting entry.

BE14-3 Assume the bonds in BE14-2 were issued at 98. Prepare the journal entries for (a) January 1, (b)July 1, and (c) December 31. Assume The Goofy Company records straight-line amortization annually onDecember 31.

BE14-4 Assume the bonds in BE14-2 were issued at 103. Prepare the journal entries for (a) January 1, (b)July 1, and (c) December 31. Assume The Goofy Company records straight-line amortization annually onDecember 31.

BE14-5 Toy Story Corporation issued $500,000 of 12% bonds on May 1, 2005. The bonds were datedJanuary 1, 2005, and mature January 1, 2010, with interest payable July 1 and January 1. The bonds wereissued at face value plus accrued interest. Prepare Toy Story’s journal entries for (a) the May 1 issuance,(b) the July 1 interest payment, and (c) the December 31 adjusting entry.

BE14-6 On January 1, 2005, Qix Corporation issued $400,000 of 7% bonds, due in 10 years. The bondswere issued for $372,816, and pay interest each July 1 and January 1. Qix uses the effective interest method.Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and(c) the December 31 adjusting entry. Assume an effective interest rate of 8%.

BE14-7 Assume the bonds in BE14-6 were issued for $429,757 and the effective interest rate is 6%. Pre-pare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and(c) the December 31 adjusting entry.

BE14-8 Izzy Corporation issued $400,000 of 7% bonds on November 1, 2005, for $429,757. The bondswere dated November 1, 2005, and mature in 10 years, with interest payable each May 1 and Novem-ber 1. Izzy uses the effective interest method with an effective rate of 6%. Prepare Izzy’s December 31,2005, adjusting entry.

BE14-9 At December 31, 2005, Treasure Land Corporation has the following account balances:

Bonds payable, due January 1, 2013 $2,000,000Discount on bonds payable 98,000Bond interest payable 80,000

Show how the above accounts should be presented on the December 31, 2005, balance sheet, includingthe proper classifications.

BE14-10 James Bond 007 Corporation issued 10-year bonds on January 1, 2005. Costs associated withthe bond issuance were $180,000. Bond uses the straight-line method to amortize bond issue costs. Pre-pare the December 31, 2005, entry to record 2002 bond issue cost amortization.

BE14-11 On January 1, 2005, Uncharted Waters Corporation retired $600,000 of bonds at 99. At the timeof retirement, the unamortized premium was $15,000 and unamortized bond issue costs were $5,250. Pre-pare the corporation’s journal entry to record the reacquisition of the bonds.

BE14-12 Jennifer Capriati, Inc. issued a $100,000, 4-year, 11% note at face value to Forest Hills Bank onJanuary 1, 2005, and received $100,000 cash. The note requires annual interest payments each December31. Prepare Capriati’s journal entries to record (a) the issuance of the note and (b) the December 31 in-terest payment.

BE14-13 Joe Montana Corporation issued a 4-year, $50,000, zero-interest-bearing note to John MaddenCompany on January 1, 2005, and received cash of $31,776. The implicit interest rate is 12%. Prepare Mon-tana’s journal entries for (a) the January 1 issuance and (b) the December 31 recognition of interest.

BE14-14 Larry Byrd Corporation issued a 4-year, $50,000, 5% note to Magic Johnson Company on Jan-uary 1, 2005, and received a computer that normally sells for $39,369. The note requires annual interestpayments each December 31. The market rate of interest for a note of similar risk is 12%. Prepare LarryByrd’s journal entries for (a) the January 1 issuance and (b) the December 31 interest.



BE14-15 King Corporation issued a 4-year, $50,000, zero-interest-bearing note to Salmon Company onJanuary 1, 2005, and received cash of $50,000. In addition, King agreed to sell merchandise to Salmon atan amount less than regular selling price over the 4-year period. The market rate of interest for similarnotes is 12%. Prepare King Corporation’s January 1 journal entry.

*BE14-16 Assume that Toni Braxton Company has recently fallen into financial difficulties. By reviewingall available evidence on December 31, 2003, one creditor of Toni Braxton, the National American Bank,determined that Toni Braxton would pay back only 65% of the principal at maturity. As a result, the bankdecided that the loan was impaired. If the loss is estimated to be $225,000, what entries should both ToniBraxton and National American Bank make to record this loss?

EXERCISESE14-1 (Classification of Liabilities) Presented below are various account balances of K.D. Lang Inc.

(a) Unamortized premium on bonds payable, of which $3,000 will be amortized during the next year.(b) Bank loans payable of a winery, due March 10, 2008. (The product requires aging for 5 years before

sale.)(c) Serial bonds payable, $1,000,000, of which $200,000 are due each July 31.(d) Amounts withheld from employees’ wages for income taxes.(e) Notes payable due January 15, 2007.(f) Credit balances in customers’ accounts arising from returns and allowances after collection in full

of account.(g) Bonds payable of $2,000,000 maturing June 30, 2006.(h) Overdraft of $1,000 in a bank account. (No other balances are carried at this bank.)(i) Deposits made by customers who have ordered goods.

InstructionsIndicate whether each of the items above should be classified on December 31, 2005, as a current liabil-ity, a long-term liability, or under some other classification. Consider each one independently from allothers; that is, do not assume that all of them relate to one particular business. If the classification of someof the items is doubtful, explain why in each case.

E14-2 (Classification) The following items are found in the financial statements.

(a) Discount on bonds payable(b) Interest expense (credit balance)(c) Unamortized bond issue costs(d) Gain on repurchase of debt(e) Mortgage payable (payable in equal amounts over next 3 years)(f) Debenture bonds payable (maturing in 5 years)(g) Notes payable (due in 4 years)(h) Premium on bonds payable(i) Treasury bonds(j) Income bonds payable (due in 3 years)

InstructionsIndicate how each of these items should be classified in the financial statements.

E14-3 (Entries for Bond Transactions) Presented below are two independent situations.

1. On January 1, 2004, Paul Simon Company issued $200,000 of 9%, 10-year bonds at par. Interest ispayable quarterly on April 1, July 1, October 1, and January 1.

2. On June 1, 2004, Graceland Company issued $100,000 of 12%, 10-year bonds dated January 1 atpar plus accrued interest. Interest is payable semiannually on July 1 and January 1.

InstructionsFor each of these two independent situations, prepare journal entries to record the following.

(a) The issuance of the bonds.(b) The payment of interest on July 1.(c) The accrual of interest on December 31.

E14-4 (Entries for Bond Transactions—Straight-Line) Celine Dion Company issued $600,000 of 10%,20-year bonds on January 1, 2005, at 102. Interest is payable semiannually on July 1 and January 1. DionCompany uses the straight-line method of amortization for bond premium or discount.

Exercises • 707


InstructionsPrepare the journal entries to record the following.

(a) The issuance of the bonds.(b) The payment of interest and the related amortization on July 1, 2005.(c) The accrual of interest and the related amortization on December 31, 2005.

E14-5 (Entries for Bond Transactions—Effective Interest) Assume the same information as in E14-4,except that Celine Dion Company uses the effective interest method of amortization for bond premiumor discount. Assume an effective yield of 9.75%.

InstructionsPrepare the journal entries to record the following. (Round to the nearest dollar.)

(a) The issuance of the bonds.(b) The payment of interest and related amortization on July 1, 2005.(c) The accrual of interest and the related amortization on December 31, 2005.

E14-6 (Amortization Schedules—Straight-line) Dan Majerle Company sells 10% bonds having amaturity value of $2,000,000 for $1,855,816. The bonds are dated January 1, 2004, and mature January 1,2009. Interest is payable annually on January 1.

InstructionsSet up a schedule of interest expense and discount amortization under the straight-line method.

E14-7 (Amortization Schedule—Effective Interest) Assume the same information as E14-6.

InstructionsSet up a schedule of interest expense and discount amortization under the effective interest method. (Hint:The effective interest rate must be computed.)

E14-8 (Determine Proper Amounts in Account Balances) Presented below are three independent situations.

(a) CeCe Winans Corporation incurred the following costs in connection with the issuance of bonds:(1) printing and engraving costs, $12,000; (2) legal fees, $49,000, and (3) commissions paid to un-derwriter, $60,000. What amount should be reported as Unamortized Bond Issue Costs, and whereshould this amount be reported on the balance sheet?

(b) George Gershwin Co. sold $2,000,000 of 10%, 10-year bonds at 104 on January 1, 2004. The bondswere dated January 1, 2004, and pay interest on July 1 and January 1. If Gershwin uses the straight-line method to amortize bond premium or discount, determine the amount of interest expense tobe reported on July 1, 2004, and December 31, 2004.

(c) Ron Kenoly Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2004, for $562,500. This priceprovided a yield of 10% on the bonds. Interest is payable semiannually on December 31 andJune 30. If Kenoly uses the effective interest method, determine the amount of interest expense torecord if financial statements are issued on October 31, 2004.

E14-9 (Entries and Questions for Bond Transactions) On June 30, 2005, Mischa Auer Company issued$4,000,000 face value of 13%, 20-year bonds at $4,300,920, a yield of 12%. Auer uses the effective interestmethod to amortize bond premium or discount. The bonds pay semiannual interest on June 30 andDecember 31.

Instructions(a) Prepare the journal entries to record the following transactions.

(1) The issuance of the bonds on June 30, 2005.(2) The payment of interest and the amortization of the premium on December 31, 2005.(3) The payment of interest and the amortization of the premium on June 30, 2006.(4) The payment of interest and the amortization of the premium on December 31, 2006.

(b) Show the proper balance sheet presentation for the liability for bonds payable on the December31, 2006, balance sheet.

(c) Provide the answers to the following questions.(1) What amount of interest expense is reported for 2006?(2) Will the bond interest expense reported in 2006 be the same as, greater than, or less than the

amount that would be reported if the straight-line method of amortization were used?(3) Determine the total cost of borrowing over the life of the bond.(4) Will the total bond interest expense for the life of the bond be greater than, the same as, or

less than the total interest expense if the straight-line method of amortization were used?



E14-10 (Entries for Bond Transactions) On January 1, 2004, Aumont Company sold 12% bonds hav-ing a maturity value of $500,000 for $537,907.37, which provides the bondholders with a 10% yield. Thebonds are dated January 1, 2004, and mature January 1, 2009, with interest payable December 31 of eachyear. Aumont Company allocates interest and unamortized discount or premium on the effective interestbasis.

Instructions(a) Prepare the journal entry at the date of the bond issuance.(b) Prepare a schedule of interest expense and bond amortization for 2004–2006.(c) Prepare the journal entry to record the interest payment and the amortization for 2004.(d) Prepare the journal entry to record the interest payment and the amortization for 2006.

E14-11 (Information Related to Various Bond Issues) Karen Austin Inc. has issued three types of debton January 1, 2004, the start of the company’s fiscal year.

(a) $10 million, 10-year, 15% unsecured bonds, interest payable quarterly. Bonds were priced to yield12%.

(b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year.(c) $20 million, 10-year, 10% mortgage bonds, interest payable annually to yield 12%.

InstructionsPrepare a schedule that identifies the following items for each bond: (1) maturity value, (2) number of in-terest periods over life of bond, (3) stated rate per each interest period, (4) effective interest rate per eachinterest period, (5) payment amount per period, and (6) present value of bonds at date of issue.

E14-12 (Entry for Retirement of Bond; Bond Issue Costs) On January 2, 1999, Banno Corporationissued $1,500,000 of 10% bonds at 97 due December 31, 2008. Legal and other costs of $24,000 were in-curred in connection with the issue. Interest on the bonds is payable annually each December 31. The$24,000 issue costs are being deferred and amortized on a straight-line basis over the 10-year term ofthe bonds. The discount on the bonds is also being amortized on a straight-line basis over the 10 years.(Straight-line is not materially different in effect from the preferable “interest method”.)

The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 2004, Banno called$900,000 face amount of the bonds and retired them.

InstructionsIgnoring income taxes, compute the amount of loss, if any, to be recognized by Banno as a result of retiringthe $900,000 of bonds in 2004 and prepare the journal entry to record the retirement.

(AICPA adapted)

E14-13 (Entries for Retirement and Issuance of Bonds) Larry Hagman, Inc. had outstanding $6,000,000of 11% bonds (interest payable July 31 and January 31) due in 10 years. On July 1, it issued $9,000,000 of10%, 15-year bonds (interest payable July 1 and January 1) at 98. A portion of the proceeds was used tocall the 11% bonds at 102 on August 1. Unamortized bond discount and issue cost applicable to the 11%bonds were $120,000 and $30,000, respectively.

InstructionsPrepare the journal entries necessary to record issue of the new bonds and the refunding of the bonds.

E14-14 (Entries for Retirement and Issuance of Bonds) On June 30, 1996, Gene Autry Company issued12% bonds with a par value of $800,000 due in 20 years. They were issued at 98 and were callable at 104at any date after June 30, 2004. Because of lower interest rates and a significant change in the company’scredit rating, it was decided to call the entire issue on June 30, 2005, and to issue new bonds. New 10%bonds were sold in the amount of $1,000,000 at 102; they mature in 20 years. Autry Company uses straight-line amortization. Interest payment dates are December 31 and June 30.

Instructions(a) Prepare journal entries to record the retirement of the old issue and the sale of the new issue on

June 30, 2005.(b) Prepare the entry required on December 31, 2005, to record the payment of the first 6 months’ in-

terest and the amortization of premium on the bonds.

E14-15 (Entries for Retirement and Issuance of Bonds) Linda Day George Company had bonds out-standing with a maturity value of $300,000. On April 30, 2005, when these bonds had an unamortizeddiscount of $10,000, they were called in at 104. To pay for these bonds, George had issued other bonds amonth earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bondswere issued at 103 (face value $300,000). Issue costs related to the new bonds were $3,000.

Exercises • 709


InstructionsIgnoring interest, compute the gain or loss and record this refunding transaction.

(AICPA adapted)

E14-16 (Entries for Non-Interest-Bearing Debt) On January 1, 2005, Ellen Greene Company makes thetwo following acquisitions.

1. Purchases land having a fair market value of $200,000 by issuing a 5-year, non-interest-bearingpromissory note in the face amount of $337,012.

2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $250,000(interest payable annually).

The company has to pay 11% interest for funds from its bank.

Instructions(a) Record the two journal entries that should be recorded by Ellen Greene Company for the two

purchases on January 1, 2005.(b) Record the interest at the end of the first year on both notes using the effective interest method.

E14-17 (Imputation of Interest) Presented below are two independent situations:

(a) On January 1, 2005, Robin Wright Inc. purchased land that had an assessed value of $350,000 atthe time of purchase. A $550,000, non-interest-bearing note due January 1, 2008, was given inexchange. There was no established exchange price for the land, nor a ready market value for thenote. The interest rate charged on a note of this type is 12%. Determine at what amount the landshould be recorded at January 1, 2005, and the interest expense to be reported in 2005 related tothis transaction.

(b) On January 1, 2005, Sally Field Furniture Co. borrowed $5,000,000 (face value) from Gary SiniseCo., a major customer, through a non-interest-bearing note due in 4 years. Because the note wasnon-interest-bearing, Sally Field Furniture agreed to sell furniture to this customer at lower thanmarket price. A 10% rate of interest is normally charged on this type of loan. Prepare the journalentry to record this transaction and determine the amount of interest expense to report for 2005.

E14-18 (Imputation of Interest with Right) On January 1, 2003, Margaret Avery Co. borrowed andreceived $400,000 from a major customer evidenced by a non-interest-bearing note due in 3 years. As con-sideration for the non-interest-bearing feature, Avery agrees to supply the customer’s inventory needs forthe loan period at lower than the market price. The appropriate rate at which to impute interest is 12%.

Instructions(a) Prepare the journal entry to record the initial transaction on January 1, 2003. (Round all compu-

tations to the nearest dollar.)(b) Prepare the journal entry to record any adjusting entries needed at December 31, 2003. Assume

that the sales of Avery’s product to this customer occur evenly over the 3-year period.

E14-19 (Long-Term Debt Disclosure) At December 31, 2003, Helen Reddy Company has outstandingthree long-term debt issues. The first is a $2,000,000 note payable which matures June 30, 2006. The sec-ond is a $6,000,000 bond issue which matures September 30, 2007. The third is a $17,500,000 sinking funddebenture with annual sinking fund payments of $3,500,000 in each of the years 2005 through 2009.

InstructionsPrepare the note disclosure required by FASB Statement No. 47, “Disclosure of Long-term Obligations,”for the long-term debt at December 31, 2003.

*E14-20 (Settlement of Debt) Larisa Nieland Company owes $200,000 plus $18,000 of accrued interestto First State Bank. The debt is a 10-year, 10% note. During 2004, Larisa Nieland’s business deteriorateddue to a faltering regional economy. On December 31, 2004, First State Bank agrees to accept an old machineand cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, anda fair market value of $190,000.

Instructions(a) Prepare journal entries for Larisa Nieland Company and First State Bank to record this debt set-

tlement.(b) How should Larisa Nieland report the gain or loss on the disposition of machine and on re-

structuring of debt in its 2004 income statement?(c) Assume that, instead of transferring the machine, Larisa Nieland decides to grant 15,000 shares

of its common stock ($10 par) which has a fair market value of $190,000 in full settlement of theloan obligation. If First State Bank treats Larisa Nieland’s stock as a trading investment, preparethe entries to record the transaction for both parties.



*E14-21 (Term Modification without Gain—Debtor’s Entries) On December 31, 2004, the Firstar Bankenters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencingfinancial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by thefollowing modifications:

1. Reducing the principal obligation from $2,000,000 to $1,600,000.2. Extending the maturity date from December 31, 2004, to December 31, 2007.3. Reducing the interest rate from 12% to 10%.

Bradtke pays interest at the end of each year. On January 1, 2008, Bradtke Company pays $1,600,000 incash to Firstar Bank.

Instructions(a) Based on FASB Statement No. 114, will the gain recorded by Bradtke be equal to the loss recorded

by Firstar Bank under the debt restructuring?(b) Can Bradtke Company record a gain under the term modification mentioned above? Explain.(c) Assuming that the interest rate Bradtke should use to compute interest expense in future periods

is 1.4276%, prepare the interest payment schedule of the note for Bradtke Company after the debtrestructuring.

(d) Prepare the interest payment entry for Bradtke Company on December 31, 2006.(e) What entry should Bradtke make on January 1, 2008?

*E14-22 (Term Modification without Gain—Creditor’s Entries) Using the same information as inE14-21 above, answer the following questions related to Firstar Bank (creditor).

Instructions(a) What interest rate should Firstar Bank use to calculate the loss on the debt restructuring?(b) Compute the loss that Firstar Bank will suffer from the debt restructuring. Prepare the journal

entry to record the loss.(c) Prepare the interest receipt schedule for Firstar Bank after the debt restructuring.(d) Prepare the interest receipt entry for Firstar Bank on December 31, 2006.(e) What entry should Firstar Bank make on January 1, 2008?

*E14-23 (Term Modification with Gain—Debtor’s Entries) Use the same information as in E14-21 aboveexcept that Firstar Bank reduced the principal to $1,300,000 rather than $1,600,000. On January 1, 2008,Bradtke pays $1,300,000 in cash to Firstar Bank for the principal.

Instructions(a) Can Bradtke Company record a gain under this term modification? If yes, compute the gain for

Bradtke Company.(b) Prepare the journal entries to record the gain on Bradtke’s books.(c) What interest rate should Bradtke use to compute its interest expense in future periods? Will your

answer be the same as in E14-21 above? Why or why not?(d) Prepare the interest payment schedule of the note for Bradtke Company after the debt restruc-

turing.(e) Prepare the interest payment entries for Bradtke Company on December 31, of 2005, 2006, and

2007.(f) What entry should Bradtke make on January 1, 2008?

*E14-24 (Term Modification with Gain—Creditor’s Entries) Using the same information as in E14-21and E14-23 above, answer the following questions related to Firstar Bank (creditor).

Instructions(a) Compute the loss Firstar Bank will suffer under this new term modification. Prepare the journal

entry to record the loss on Firstar’s books.(b) Prepare the interest receipt schedule for Firstar Bank after the debt restructuring.(c) Prepare the interest receipt entry for Firstar Bank on December 31, 2005, 2006, and 2007.(d) What entry should Firstar Bank make on January 1, 2008?

*E14-25 (Debtor/Creditor Entries for Settlement of Troubled Debt) Petra Langrova Co. owes $199,800to Mary Joe Fernandez Inc. The debt is a 10-year, 11% note. Because Petra Langrova Co. is in financialtrouble, Mary Joe Fernandez Inc. agrees to accept some property and cancel the entire debt. The propertyhas a book value of $80,000 and a fair market value of $120,000.

Instructions(a) Prepare the journal entry on Langrova’s books for debt restructure.(b) Prepare the journal entry on Fernandez’s books for debt restructure.

Exercises • 711


*E14-26 (Debtor/Creditor Entries for Modification of Troubled Debt) Steffi Graf Corp. owes $225,000to First Trust. The debt is a 10-year, 12% note due December 31, 2004. Because Graf Corp. is in financialtrouble, First Trust agrees to extend the maturity date to December 31, 2006, reduce the principal to$200,000, and reduce the interest rate to 5%, payable annually on December 31.

Instructions(a) Prepare the journal entries on Graf’s books on December 31, 2004, 2005, 2006.(b) Prepare the journal entries on First Trust’s books on December 31, 2004, 2005, 2006.

*E14-27 (Impairments) On December 31, 2003, Iva Majoli Company borrowed $62,092 from Paris Bank,signing a 5-year, $100,000 non-interest-bearing note. The note was issued to yield 10% interest. Unfortu-nately, during 2005, Majoli began to experience financial difficulty. As a result, at December 31, 2005, ParisBank determined that it was probable that it would receive back only $75,000 at maturity. The market rateof interest on loans of this nature is now 11%.

Instructions(a) Prepare the entry to record the issuance of the loan by Paris Bank on December 31, 2003.(b) Prepare the entry (if any) to record the impairment of the loan on December 31, 2005, by Paris

Bank.(c) Prepare the entry (if any) to record the impairment of the loan on December 31, 2005, by Majoli

Company.

*E14-28 (Impairments) On December 31, 2002, Conchita Martinez Company signed a $1,000,000 noteto Sauk City Bank. The market interest rate at that time was 12%. The stated interest rate on the note was10%, payable annually. The note matures in 5 years. Unfortunately, because of lower sales, Conchita Mar-tinez’s financial situation worsened. On December 31, 2004, Sauk City Bank determined that it was prob-able that the company would pay back only $600,000 of the principal at maturity. However, it was con-sidered likely that interest would continue to be paid, based on the $1,000,000 loan.

Instructions(a) Determine the amount of cash Conchita Martinez received from the loan on December 31, 2002.(b) Prepare a note amortization schedule for Sauk City Bank up to December 31, 2004.(c) Determine the loss on impairment that Sauk City Bank should recognize on December 31, 2004.

PROBLEMSP14-1 (Analysis of Amortization Schedule and Interest Entries) The following amortization and in-terest schedule reflects the issuance of 10-year bonds by Terrel Brandon Corporation on January 1, 1997,and the subsequent interest payments and charges. The company’s year-end is December 31, and finan-cial statements are prepared once yearly.

Amortization Schedule

Amount BookYear Cash Interest Unamortized Value

1/1/97 $5,651 $ 94,3491997 $11,000 $11,322 5,329 94,6711998 11,000 11,361 4,968 95,0321999 11,000 11,404 4,564 95,4362000 11,000 11,452 4,112 95,8882001 11,000 11,507 3,605 96,3952002 11,000 11,567 3,038 96,9622003 11,000 11,635 2,403 97,5972004 11,000 11,712 1,691 98,3092005 11,000 11,797 894 99,1062006 11,000 11,894 100,000

Instructions(a) Indicate whether the bonds were issued at a premium or a discount and how you can determine

this fact from the schedule.(b) Indicate whether the amortization schedule is based on the straight-line method or the effective

interest method and how you can determine which method is used.(c) Determine the stated interest rate and the effective interest rate.



(d) On the basis of the schedule above, prepare the journal entry to record the issuance of the bondson January 1, 1997.

(e) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond trans-actions and accruals for 1997. (Interest is paid January 1.)

(f) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond trans-actions and accruals for 2004. Brandon Corporation does not use reversing entries.

P14-2 (Issuance and Retirement of Bonds) Sam Sluggers Co. is building a new hockey arena at a costof $2,000,000. It received a downpayment of $500,000 from local businesses to support the project, andnow needs to borrow $1,500,000 to complete the project. It therefore decides to issue $1,500,000 of 10.5%,10-year bonds. These bonds were issued on January 1, 2002, and pay interest annually on each January 1.The bonds yield 10%. Sluggers paid $50,000 in bond issue costs related to the bond sale.

Instructions(a) Prepare the journal entry to record the issuance of the bonds and the related bond issue costs in-

curred on January 1, 2002.(b) Prepare a bond amortization schedule up to and including January 1, 2006, using the effective in-

terest method.(c) Assume that on July 1, 2005, Sam Sluggers Co. retires half of the bonds at a cost of $800,000 plus

accrued interest. Prepare the journal entry to record this retirement.

P14-3 (Negative Amortization) Slippery Sales Inc. developed a new sales gimmick to help sell itsinventory of new automobiles. Because many new car buyers need financing, Slippery offered a low down-payment and low car payments for the first year after purchase. It believes that this promotion will bringin some new buyers.

On January 1, 2004, a customer purchased a new $25,000 automobile, making a downpayment of $1,000.The customer signed a note indicating that the annual rate of interest would be 8% and that quarterlypayments would be made over 3 years. For the first year, Slippery required a $300 quarterly payment tobe made on April 1, July 1, October 1, and January 1, 2005. After this one-year period, the customer wasrequired to make regular quarterly payments that would pay off the loan as of January 1, 2007.

Instructions(a) Prepare a note amortization schedule for the first year.(b) Indicate the amount the customer owes on the contract at the end of the first year.(c) Compute the amount of the new quarterly payments.(d) Prepare a note amortization schedule for these new payments for the next 2 years.(e) What do you think of the new sales promotion used by Slippery?

P14-4 (Issuance and Retirement of Bonds; Income Statement Presentation) Chris Mills Companyissued its 9%, 25-year mortgage bonds in the principal amount of $5,000,000 on January 2, 1990, at a dis-count of $250,000, which it proceeded to amortize by charges to expense over the life of the issue on astraight-line basis. The indenture securing the issue provided that the bonds could be called for redemp-tion in total but not in part at any time before maturity at 104% of the principal amount, but it did notprovide for any sinking fund.

On December 18, 2004, the company issued its 11%, 20-year debenture bonds in the principal amountof $6,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2,2005. The indenture securing the new issue did not provide for any sinking fund or for retirement beforematurity.

Instructions(a) Prepare journal entries to record the issuance of the 11% bonds and the retirement of the 9% bonds.(b) Indicate the income statement treatment of the gain or loss from retirement and the note disclo-

sure required.

P14-5 (Comprehensive Bond Problem) In each of the following independent cases the company closesits books on December 31.

1. Danny Ferry Co. sells $250,000 of 10% bonds on March 1, 2004. The bonds pay interest on Sep-tember 1 and March 1. The due date of the bonds is September 1, 2007. The bonds yield 12%. Giveentries through December 31, 2005.

2. Brad Dougherty Co. sells $600,000 of 12% bonds on June 1, 2004. The bonds pay interest onDecember 1 and June 1. The due date of the bonds is June 1, 2008. The bonds yield 10%. On October 1, 2005, Dougherty buys back $120,000 worth of bonds for $126,000 (includes accruedinterest). Give entries through December 1, 2006.

Problems • 713


Instructions(Round to the nearest dollar.)

For the two cases prepare all of the relevant journal entries from the time of sale until the date indicated.Use the effective interest method for discount and premium amortization (construct amortization tableswhere applicable). Amortize premium or discount on interest dates and at year-end. (Assume that no re-versing entries were made.)

P14-6 (Issuance of Bonds between Interest Dates, Straight-line, Retirement) Presented below areselected transactions on the books of Michael Cage Powerglide Corporation.

May 1, 2004 Bonds payable with a par value of $700,000, which are dated January 1, 2004, are sold at106 plus accrued interest. They are coupon bonds, bear interest at 12% (payable annuallyat January 1), and mature January 1, 2014. (Use interest expense account for accruedinterest.)

Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and theamortization of the proper amount of premium. (Use straight-line amortization.)

Jan. 1, 2005 Interest on the bonds is paid.April 1 Bonds of par value of $420,000 are purchased at 102 plus accrued interest, and retired.

(Bond premium is to be amortized only at the end of each year.)Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the proper

amount of premium amortized.

InstructionsPrepare journal entries for the transactions above.

P14-7 (Entries for Life Cycle of Bonds) On April 1, 2004, Jerry Fontenot Company sold 12,000 of its11%, 15-year, $1,000 face value bonds at 97. Interest payment dates are April 1 and October 1, and thecompany uses the straight-line method of bond discount amortization. On March 1, 2005, Fontenot tookadvantage of favorable prices of its stock to extinguish 3,000 of the bonds by issuing 100,000 shares of its$10 par value common stock. At this time, the accrued interest was paid in cash. The company’s stockwas selling for $31 per share on March 1, 2005.

InstructionsPrepare the journal entries needed on the books of Fontenot Company to record the following.

(a) April 1, 2004: issuance of the bonds.(b) October 1, 2004: payment of semiannual interest.(c) December 31, 2004: accrual of interest expense.(d) March 1, 2005: extinguishment of 3,000 bonds. (No reversing entries made.)

P14-8 (Entries for Non-Interest-Bearing Debt) On December 31, 2004, Jose Luis Company acquired acomputer from Cuevas Corporation by issuing a $400,000 non-interest-bearing note, payable in full onDecember 31, 2008. Jose Luis Company’s credit rating permits it to borrow funds from its several lines ofcredit at 10%. The computer is expected to have a 5-year life and a $50,000 salvage value.

Instructions(a) Prepare the journal entry for the purchase on December 31, 2004.(b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortiza-

tion (use effective interest method) on December 31, 2005.(c) Prepare any necessary adjusting entries relative to depreciation and amortization on December

31, 2006.

P14-9 (Entries for Non-Interest-Bearing Debt; Payable in Installments) Sun Yat-sen Cosmetics Co.purchased machinery on December 31, 2003, paying $40,000 down and agreeing to pay the balance infour equal installments of $30,000 payable each December 31. An assumed interest of 12% is implicit inthe purchase price.

InstructionsPrepare the journal entries that would be recorded for the purchase and for the payments and interest onthe following dates.

(a) December 31, 2003. (d) December 31, 2006.(b) December 31, 2004. (e) December 31, 2007.(c) December 31, 2005.



P14-10 (Comprehensive Problem; Issuance, Classification, Reporting) Presented below are four in-dependent situations.

(a) On March 1, 2005, Heide Co. issued at 103 plus accrued interest $3,000,000, 9% bonds. The bondsare dated January 1, 2005, and pay interest semiannually on July 1 and January 1. In addition,Heide Co. incurred $27,000 of bond issuance costs. Compute the net amount of cash received byHeide Co. as a result of the issuance of these bonds.

(b) On January 1, 2004, Reymont Co. issued 9% bonds with a face value of $500,000 for $469,280 toyield 10%. The bonds are dated January 1, 2004, and pay interest annually. What amount is reportedfor interest expense in 2004 related to these bonds, assuming that Reymont used the effectiveinterest method for amortizing bond premium and discount?

(c) Czeslaw Building Co. has a number of long-term bonds outstanding at December 31, 2005. Theselong-term bonds have the following sinking fund requirements and maturities for the next 6 years.

Sinking Fund Maturities

2006 $300,000 $100,0002007 100,000 250,0002008 100,000 100,0002009 200,000 — 2010 200,000 150,0002011 200,000 100,000

Indicate how this information should be reported in the financial statements at December 31, 2005.(d) In the long-term debt structure of Marie Curie Inc., the following three bonds were reported: mort-

gage bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in installments,secured by plant equipment $4,000,000. Determine the total amount, if any, of debenture bondsoutstanding.

P14-11 (Effective Interest Method) Mathilda B. Reichenbacher, an intermediate accounting student, ishaving difficulty amortizing bond premiums and discounts using the effective interest method. Further-more, she cannot understand why GAAP requires that this method be used instead of the straight-linemethod. She has come to you with the following problem, looking for help.

On June 30, 2003, Joan Elbert Company issued $3,000,000 face value of 13%, 20-year bonds at $3,225,690,a yield of 12%. Elbert Company uses the effective interest method to amortize bond premiums or discounts.The bonds pay semiannual interest on June 30 and December 31. Compute the amortization schedule forfour periods.

InstructionsUsing the data above for illustrative purposes, write a short memo (1–1.5 pages double-spaced) toMathilda, explaining what the effective interest method is, why it is preferable, and how it is computed.(Do not forget to include an amortization schedule, referring to it whenever necessary.)

*P14-12 (Loan Impairment Entries) On January 1, 2004, Bostan Company issued a $1,200,000, 5-year,zero-interest-bearing note to National Organization Bank. The note was issued to yield 8% annual inter-est. Unfortunately, during 2005, Bostan fell into financial trouble due to increased competition. Afterreviewing all available evidence on December 31, 2005, National Organization Bank decided that the loanwas impaired. Bostan will probably pay back only $800,000 of the principal at maturity.

Instructions(a) Prepare journal entries for both Bostan Company and National Organization Bank to record the

issuance of the note on January 1, 2004. (Round to the nearest $10.)(b) Assuming that both Bostan Company and National Organization Bank use the effective interest

method to amortize the discount, prepare the amortization schedule for the note.(c) Under what circumstances can National Organization Bank consider Bostan’s note to be

“impaired”?(d) Compute the loss National Organization Bank will suffer from Bostan’s financial distress on

December 31, 2005. What journal entries should be made to record this loss?

*P14-13 (Debtor/Creditor Entries for Continuation of Troubled Debt) Jeremy Hillary is the sole share-holder of Hillary Inc., which is currently under protection of the U.S. bankruptcy court. As a “debtor inpossession,” he has negotiated the following revised loan agreement with Valley Bank. Hillary Inc.’s$400,000, 12%, 10-year note was refinanced with a $400,000, 5%, 10-year note.

Instructions(a) What is the accounting nature of this transaction?(b) Prepare the journal entry to record this refinancing:

Problems • 715


(1) On the books of Hillary Inc.(2) On the books of Valley Bank.

(c) Discuss whether generally accepted accounting principles provide the proper information usefulto managers and investors in this situation.

*P14-14 (Restructure of Note under Different Circumstances) Sandro Corporation is having financialdifficulty and therefore has asked Botticelli National Bank to restructure its $3 million note outstanding.The present note has 3 years remaining and pays a current rate of interest of 10%. The present marketrate for a loan of this nature is 12%. The note was issued at its face value.

InstructionsPresented below are four independent situations. Prepare the journal entry that Sandro and BotticelliNational Bank would make for each of these restructurings.

(a) Botticelli National Bank agrees to take an equity interest in Sandro by accepting common stockvalued at $2,200,000 in exchange for relinquishing its claim on this note. The common stock hasa par value of $1,000,000.

(b) Botticelli National Bank agrees to accept land in exchange for relinquishing its claim on this note.The land has a book value of $1,950,000 and a fair value of $2,400,000.

(c) Botticelli National Bank agrees to modify the terms of the note, indicating that Sandro does nothave to pay any interest on the note over the 3-year period.

(d) Botticelli National Bank agrees to reduce the principal balance due to $2,500,000 and requireinterest only in the second and third year at a rate of 10%.

*P14-15 (Debtor/Creditor Entries for Continuation of Troubled Debt with New Effective Interest)Mildred Corp. owes D. Taylor Corp. a 10-year, 10% note in the amount of $110,000 plus $11,000 of accruedinterest. The note is due today, December 31, 2004. Because Mildred Corp. is in financial trouble, D. TaylorCorp. agrees to forgive the accrued interest, $10,000 of the principal, and to extend the maturity date toDecember 31, 2007. Interest at 10% of revised principal will continue to be due on 12/31 each year.

Assume the following present value factors for 3 periods.

21/4% 23/8% 21/2% 25/8% 23/4% 3%

Single sum .93543 .93201 .92859 .92521 .92184 .91514Ordinary annuity of 1 2.86989 2.86295 2.85602 2.84913 2.84226 2.82861

Instructions(a) Compute the new effective interest rate for Mildred Corp. following restructure. (Hint: Find the

interest rate that establishes approximately $121,000 as the present value of the total future cashflows.)

(b) Prepare a schedule of debt reduction and interest expense for the years 2004 through 2007.(c) Compute the gain or loss for D. Taylor Corp. and prepare a schedule of receivable reduction and

interest revenue for the years 2004 through 2007.(d) Prepare all the necessary journal entries on the books of Mildred Corp. for the years 2004, 2005,

and 2006.(e) Prepare all the necessary journal entries on the books of D. Taylor Corp. for the years 2004, 2005,

and 2006.

CONCEPTUAL CASESC14-1 (Bond Theory: Balance Sheet Presentations, Interest Rate, Premium) On January 1, 2005,Branagh Company issued for $1,075,230 its 20-year, 13% bonds that have a maturity value of $1,000,000and pay interest semiannually on January 1 and July 1. Bond issue costs were not material in amount.Below are three presentations of the long-term liability section of the balance sheet that might be used forthese bonds at the issue date.

1. Bonds payable (maturing January 1, 2025) $1,000,000Unamortized premium on bonds payable 75,230

Total bond liability $1,075,230

2. Bonds payable—principal (face value $1,000,000 maturingJanuary 1, 2025) $ 97,220a

Bonds payable—interest (semiannual payment $65,000) 978,010b




3. Bonds payable—principal (maturing January 1, 2025) $1,000,000Bonds payable—interest ($65,000 per period for 40 periods) 2,600,000


aThe present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 6% per period.bThe present value of $65,000 per period for 40 (6-month) periods at the yield rate of 6% per period.

Instructions(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown

above for these bonds.(b) Explain why investors would pay $1,075,230 for bonds that have a maturity value of only

$1,000,000.(c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising

from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of us-ing for this purpose:(1) The coupon or nominal rate.(2) The effective or yield rate at date of issue.

(d) If the obligations arising from these bonds are to be carried at their present value computed bymeans of the current market rate of interest, how would the bond valuation at dates subsequentto the date of issue be affected by an increase or a decrease in the market rate of interest?

(AICPA adapted)

C14-2 (Various Long-Term Liability Conceptual Issues) Emma Thompson Company has completeda number of transactions during 2004. In January the company purchased under contract a machine at atotal price of $1,200,000, payable over 5 years with installments of $240,000 per year. The seller has con-sidered the transaction as an installment sale with the title transferring to Thompson at the time of thefinal payment.

On March 1, 2004, Thompson issued $10 million of general revenue bonds priced at 99 with a couponof 10% payable July 1 and January 1 of each of the next 10 years. The July 1 interest was paid and onDecember 30 the company transferred $1,000,000 to the trustee, Hollywood Trust Company, for paymentof the January 1, 2005, interest.

Due to the depressed market for the company’s stock, Thompson purchased $500,000 par value of their6% convertible bonds for a price of $455,000. It expects to resell the bonds when the price of its stock hasrecovered.

As the accountant for Emma Thompson Company, you have prepared the balance sheet as of December31, 2004, and have presented it to the president of the company. You are asked the following questionsabout it.

1. Why has depreciation been charged on equipment being purchased under contract? Title has notpassed to the company as yet and, therefore, they are not our assets. Why should the company notshow on the left side of the balance sheet only the amount paid to date instead of showing the fullcontract price on the left side and the unpaid portion on the right side? After all, the seller con-siders the transaction an installment sale.

2. What is bond discount? As a debit balance, why is it not classified among the assets?3. Bond interest is shown as a current liability. Did we not pay our trustee, Hollywood Trust Com-

pany, the full amount of interest due this period?4. Treasury bonds are shown as a deduction from bonds payable issued. Why should they not be

shown as an asset, since they can be sold again? Are they the same as bonds of other companiesthat we hold as investments?

InstructionsOutline your answers to these questions by writing a brief paragraph that will justify your treatment.

C14-3 (Bond Theory: Price, Presentation, and Retirement) On March 1, 2005, Chuck Norris Companysold its 5-year, $1,000 face value, 9% bonds dated March 1, 2005, at an effective annual interest rate (yield)of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2005. Norrisuses the effective interest method of amortization. Bond issue costs were incurred in preparing and sell-ing the bond issue. The bonds can be called by Norris at 101 at any time on or after March 1, 2006.

Instructions(a) (1) How would the selling price of the bond be determined?

(2) Specify how all items related to the bonds would be presented in a balance sheet preparedimmediately after the bond issue was sold.

(b) What items related to the bond issue would be included in Norris’ 2005 income statement, andhow would each be determined?

Conceptual Cases • 717


(c) Would the amount of bond discount amortization using the effective interest method of amorti-zation be lower in the second or third year of the life of the bond issue? Why?

(d) Assuming that the bonds were called in and retired on March 1, 2006, how should Norris reportthe retirement of the bonds on the 2006 income statement?

(AICPA adapted)

C14-4 (Bond Theory: Amortization and Gain or Loss Recognition)Part I. The appropriate method of amortizing a premium or discount on issuance of bonds is the effec-tive interest method.

Instructions(a) What is the effective interest method of amortization and how is it different from and similar to

the straight-line method of amortization?(b) How is amortization computed using the effective interest method, and why and how do amounts

obtained using the effective interest method differ from amounts computed under the straight-line method?

Part II. Gains or losses from the early extinguishment of debt that is refunded can theoretically be ac-counted for in three ways:

1. Amortized over remaining life of old debt.2. Amortized over the life of the new debt issue.3. Recognized in the period of extinguishment.

Instructions(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains

and losses from the early extinguishment of debt.(b) Which of the methods above is generally accepted and how should the appropriate amount of

gain or loss be shown in a company’s financial statements?(AICPA adapted)

C14-5 (Off-Balance-Sheet Financing) Brad Pitt Corporation is interested in building its own soda canmanufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensurea steady supply of cans at a stable price and to minimize transportation costs. However, the company hasbeen experiencing some financial problems and has been reluctant to borrow any additional cash to fundthe project. The company is not concerned with the cash flow problems of making payments, but ratherwith the impact of adding additional long-term debt to their balance sheet.

The president of Pitt, Aidan Quinn, approached the president of the Aluminum Can Company (ACC),their major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrange-ment, since it seemed inevitable that Pitt would begin their own can production. The Aluminum CanCompany could not afford to lose the account.

After some discussion a two part plan was worked out. First ACC was to construct the plant on Pitt’sland adjacent to the existing plant. Second, Pitt would sign a 20-year purchase agreement. Under the pur-chase agreement, Pitt would express its intention to buy all of its cans from ACC, paying a unit pricewhich at normal capacity would cover labor and material, an operating management fee, and the debtservice requirements on the plant. The expected unit price, if transportation costs are taken into consid-eration, is lower than current market. If Pitt did not take enough production in any one year and if theexcess cans could not be sold at a high enough price on the open market, Pitt agrees to make up any cashshortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-yearloan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years theplant is to become the property of Pitt.

Instructions(a) What are project financing arrangements using special purpose entities?(b) What are take-or-pay contracts?(c) Should Pitt record the plant as an asset together with the related obligation?(d) If not, should Pitt record an asset relating to the future commitment?(e) What is meant by off-balance-sheet financing?

C14-6 (Bond Issue) Roland Carlson is the president, founder, and majority owner of Thebeau MedicalCorporation, an emerging medical technology products company. Thebeau is in dire need of additionalcapital to keep operating and to bring several promising products to final development, testing, and pro-duction. Roland, as owner of 51% of the outstanding stock, manages the company’s operations. He placesheavy emphasis on research and development and long-term growth. The other principal stockholder isJana Kingston who, as a nonemployee investor, owns 40% of the stock. Jana would like to deemphasize



Using Your Judgment • 719

USING YOUR JUDGMENT

the R & D functions and emphasize the marketing function to maximize short-run sales and profits fromexisting products. She believes this strategy would raise the market price of Thebeau’s stock.

All of Roland’s personal capital and borrowing power is tied up in his 51% stock ownership. Heknows that any offering of additional shares of stock will dilute his controlling interest because he won’tbe able to participate in such an issuance. But, Jana has money and would likely buy enough shares togain control of Thebeau. She then would dictate the company’s future direction, even if it meant replac-ing Roland as president and CEO.

The company already has considerable debt. Raising additional debt will be costly, will adverselyaffect Thebeau’s credit rating, and will increase the company’s reported losses due to the growth in in-terest expense. Jana and the other minority stockholders express opposition to the assumption of addi-tional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his con-trol and to preserve the direction of “his” company, Roland is doing everything to avoid a stock issuanceand is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.

Instructions(a) Who are the stakeholders in this situation?(b) What are the ethical issues in this case?(c) What would you do if you were Roland?

FINANCIAL REPORTING PROBLEM

3M CompanyThe financial statements of 3M are presented in Appendix 5B or can be accessed on the Take Action! CD.

InstructionsRefer to 3M’s financial statements and the accompanying notes to answer the following questions.(a) What cash outflow obligations related to the repayment of long-term debt does 3M have over the next

5 years?(b) 3M indicates that it believes that it has the ability to meet business requirements in the foreseeable

future. Prepare an assessment of its solvency and financial flexibility using ratio analysis.

FINANCIAL STATEMENT ANALYSIS CASES

Case 1 Commonwealth Edison Co.The following article appeared in the Wall Street Journal.

Bond MarketsGiant Commonwealth Edison Issue Hits Resale Market With $70 Million Left OverNEW YORK—Commonwealth Edison Co.’s slow-selling new 91/4% bonds were tossed onto the resalemarket at a reduced price with about $70 million still available from the $200 million offered Thurs-day, dealers said.

The Chicago utility’s bonds, rated double-A by Moody’s and double-A-minus by Standard &Poor’s, originally had been priced at 99.803, to yield 9.3% in 5 years. They were marked down yes-terday the equivalent of about $5.50 for each $1,000 face amount, to about 99.25, where their yieldjumped to 9.45%.


Instructions(a) How will the development above affect the accounting for Commonwealth Edison’s bond issue?(b) Provide several possible explanations for the markdown and the slow sale of Commonwealth Edison’s

bonds.

Case 2 PepsiCo, Inc.PepsiCo, Inc. based in Purchase, New York, is a leading company in the beverage industry.Assume that the following events occurred relating to PepsiCo’s long-term debt in a recent year.� The company decided on February 1 to refinance $500 million in short-term 7.4% debt to make it long-

term 6%.� $780 million of long-term zero-coupon bonds with an effective interest rate of 10.1% matured July 1

and were paid.� On October 1, the company issued $200 million in Australian dollar 6.3% bonds at 102 and $95 mil-

lion in Italian lira 11.4% bonds at 99.� The company holds $100 million in perpetual foreign interest payment bonds that were issued in 1989,

and presently have a rate of interest of 5.3%. These bonds are called perpetual because they have nostated due date. Instead, at the end of every 10-year period after the bond’s issuance, the bondhold-ers and PepsiCo have the option of redeeming the bonds. If either party desires to redeem the bonds,the bonds must be redeemed. If the bonds are not redeemed, a new interest rate is set, based on thethen-prevailing interest rate for 10-year bonds. The company does not intend to cause redemption ofthe bonds, but will reclassify this debt to current next year, since the bondholders could decide toredeem the bonds.

Instructions(a) Consider event 1. What are some of the reasons the company may have decided to refinance this

short-term debt, besides lowering the interest rate?(b) What do you think are the benefits to the investor in purchasing zero-coupon bonds, such as those

described in event 2? What journal entry would be required to record the payment of these bonds?If financial statements are prepared each December 31, in which year would the bonds have been in-cluded in short-term liabilities?

(c) Make the journal entry to record the bond issue described in event 3. Note that the bonds were is-sued on the same day, yet one was issued at a premium and the other at a discount. What are someof the reasons that this may have happened?

(d) What are the benefits to PepsiCo in having perpetual bonds as described in event 4? Suppose that inthe current year the bonds are not redeemed and the interest rate is adjusted to 6% from 7.5%. Makeall necessary journal entries to record the renewal of the bonds and the change in rate.

COMPARATIVE ANALYSIS CASE

The Coca-Cola Company and PepsiCo, Inc.

InstructionsGo to the Take Action! CD and use information found there to answer the following questions related toThe Coca-Cola Company and Pepsi Co, Inc.(a) Compute the debt to total assets ratio and the times interest earned ratio for these two companies.

Comment on the quality of these two ratios for both Coca-Cola and PepsiCo.(b) What is the difference between the fair value and the historical cost (carrying amount) of each com-

pany’s debt at year-end 2001? Why might a difference exist in these two amounts?(c) Both companies have debt issued in foreign countries. Speculate as to why these companies may use

foreign debt to finance their operations. What risks are involved in this strategy, and how might theyadjust for this risk?


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Using Your Judgment • 721

RESEARCH CASES

Case 1

InstructionsUse an appropriate source (such as those identified in Chapter 2 Research Case 1) to identify a firm thatrecently had its bond rating changed. Answer the following questions.(a) Which rating agency(ies) changed the rating?(b) What was the bond rating before and after the change?(c) What reasons did the rating agency give in support of its action? What accounting data was used as

support?(d) Are additional changes possible?

Case 2The February 2, 2002, edition of the Wall Street Journal includes an article by Mark Maremount entitled“Tyco May Alter Plan to Buy Back $11 Billion in Bonds with Tenders.” (Subscribers to Business Extra canaccess the article at that site.)

InstructionsRead the article and answer the following questions.(a) Tyco had announced earlier that it intended to “tender” for $11 billion of its bonds. Now it says it

may repurchase the bonds in the open market. What’s the difference between a “tender” and an open-market purchase?

(b) How would the transaction (tender or repurchase) be reported in the income statement? That is, whatamount would be reported, and where would it appear?

(c) Under U.S. GAAP, should Tyco write down its bonds to their current market value? What account-ing principle would justify this treatment?

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PROFESSIONAL SIMULATION

Directions

In this simulation, you will be asked various questions concerning the accounting for long-term liabilities.Prepare responses to all parts.

Situation

Long-Term Liabilities

Journal Entry

Prepare the journal entry for the issuance of the bonds and on the first interest payment date.

Resources

Use a computer spreadsheet to prepare an amortization schedule for the bonds.

Financial Statements

Prepare the long-term liabilities section of the balance sheet and appropriate notes to the financialstatements for Balzac Inc. as of March 31, 2003.

Research ResourcesDirections Situation JournalEntries

Honoré de Balzac Inc. has been producing quality children’s apparel for more than 25 years. Thecompany’s fiscal year runs from April 1 to March 31. The following information relates to theobligations of Balzac as of March 31, 2003.

Bonds PayableBalzac issued $5,000,000 of 11% bonds on April 1, 2002. Market interest rates on that date for bondsof similar risk were 10%. Bonds mature on April 1, 2012; interest is paid annually on April 1.

Notes PayableBalzac has signed several long-term notes with financial institutions and insurance companies.The maturities of these notes are given in the schedule below. The total unpaid interest for all ofthese notes amounts to $210,000 on March 31, 2003.

Due Date Amount DueApril 1, 2003 $ 200,000July 1, 2003 300,000October 1, 2003 150,000January 1, 2004 150,000April 1, 2004–March 31, 2005 600,000April 1, 2005–March 31, 2006 500,000

$1,900,000

Asset Retirement ObligationBalzac purchased a warehouse in 1998 for $300,000. In February 2003, due to the passage of a newwetlands restoration law, Balzac will be required to restore the wetlands surrounding the warehousesite when the warehouse is abandoned in 2007. Balzac has estimated that the present value of the costto restore the site is $35,000.

FinancialStatements

Remember to check the Take Action! CDand the book’s companion Web site

to find additional resources for this chapter.

www.w

iley.

com/college/kieso

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Long-Term Liabilities - Wiley

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