TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Lisa Harvey, CPA, CA Rotman School of Management, University of Toronto 14 CHAPTER 14 Long-Term.

TENTH CANADIAN EDITION

INTERMEDIATE ACCOUNTING

Prepared by:

Lisa Harvey, CPA, CARotman School of Management,

University of Toronto

CHAPTER 14Long-Term Financial

Liabilities

Kieso • Weygandt • Warfield • Young • Wiecek • McConomy

CHAPTER

Copyright © John Wiley & Sons Canada, Ltd.

2

14

After studying this chapter, you should be able to:

• Understand the nature of long-term debt financing arrangements.• Understand how long-term debt is measured and accounted for.• Understand when long-term debt is recognized and derecognized,

including how to account for troubled debt restructurings.• Explain how long-term debt is presented on the statement of financial

position.• Identify disclosure requirements.• Calculate and interpret key ratios related to solvency and liquidity.• Identify major differences in accounting standards between IFRS and

ASPE, and what changes are expected in the near future.

LONG-TERM FINANCIAL LIABILITIES

3Copyright © John Wiley & Sons Canada, Ltd.

Long-Term Financial Liabilities

3

Understanding Debt Instruments• Bonds and

notes payable

• Credit ratings

• Defeasance

• Types of companies that have significant debt financing

• Information for decision-making

Recognition and Derecognition• Repayment

before maturity date

• Exchange of debt instruments

• Troubled debt restructurings

• Defeasance revisited

• Off-balance sheet financing

Measurement • Bonds and notes

issued at par

• Discounts and premiums

• Special situations

Presentation, Disclosure, and Analysis• Presentation

• Disclosures

• Analysis

IFRS/ASPE Comparison• A comparison

of IFRS and ASPE

• Looking ahead


Issuing Long-Term Debt

• Obligations not payable within one year, or one business operating cycle—whichever is longer

• Examples include:– Bonds payable– Long-term notes payable– Mortgages– Pension liabilities– Lease liabilities

• Often with restrictive covenants (terms) attached

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Bonds

• Most common type of long-term debt• A bond indenture is a promise (by the

lender to the borrower) to pay:• a sum of money at the designated date, and• periodic interest (usually paid semi-annually)

at a stipulated rate on the face value.• A bond issue may be sold:

• either through an investment banker, or• by private placement.

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Notes Payable

• Similar in nature to bonds– Require repayment of principal at a future date– Require periodic interest payments

• The difference is that notes do not normally trade on public markets

• Accounting for bonds and notes is the same in many respects

• Like a bond, a note is recorded at the PV of future interest and principal, and any premium/discount is amortized over the life of the note

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Types of Bonds/Notes

• Bearer (coupon) bonds: are freely transferable by current owner

• Secured debt: secured by collateral (real estate, stocks)• Serial bonds: mature in instalments• Income and revenue bonds: interest payments tied to

some form of performance• Deep-discount bonds: little or no interest payments; sold

at a substantial discount• Callable bonds: give issuer right to call and retire debt

prior to maturity• Convertible bonds: can be converted into other

corporate securities

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Bond Ratings

• Companies such as Moody’s Investors Service and Standard & Poor’s Corporation assess credit ratings of company bonds and preferred shares

• Bonds ratings range from a quality of “Prime” to “Very speculative”

• AAA rating indicates a rating of “Prime”, while a B rating indicates a “very speculative” rating

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Defeasance

• Sufficient funds set aside (i.e. in a trust) to pay off principal and interest of debt

• “Legal defeasance” occurs when the creditor no longer has claim on the assets of the original issuer– Trust held responsible for repayment

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Types of Companies with Significant Debt Financing

• Financing can be obtained from borrowing, issuing equity (shares) or using internally generated funds

• Capital-intensive industries have a greater ability to borrow funds because the loans are secured by the underlying tangible assets– Examples include transportation and hotel

companies


Information for Decision-Making

• It is important for companies to monitor financial ratios in order to ensure that they take advantage of leverage without becoming overextended– Cash flows must be managed in order to

continue to operate, maximize profit and benefit from opportunities



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notes payable

• Credit ratings

• Defeasance









Measurement • Bonds and

notes issued at par




• Disclosures

• Analysis


of IFRS and ASPE

• Looking ahead


Bond Measurement: Determining Bond Prices

• The price of a bond is determined by finding the present value (PV) of future cash flows:• the PV of the interest payments (at the stated ,

coupon or nominal rate of interest) plus• the PV of the principal amount (also called the face

value, par value or maturity value)

• Both amounts are discounted at the market (yield) rate of interest in effect at issue date

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Bond Measurement: Determining Bond Prices

• When the effective yield (market rate) = stated rate bond sells at par

• When the effective yield (market rate) stated rate bond sells at a discount

• When the effective yield (market rate) stated rate bond sells at a premium


Bond Measurement: Bond Price Calculation

Given:• Face value of bond issue: $100,000• Term of issue: 5 years• Stated interest rate: 9% per year,

payable annually at year end• Market rate of interest: 11%

Determine the issue price of the bonds

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16

Year 1 Year 2 Year 3 Year 4 Year 5

$9,000 $9,000 $9,000 $9,000 $9,000

Interestannuity

$100,000

Face Value

Discount the future cash flowsusing the effective yield



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Discount at effective yield, 11%$9,000 x 3.69590

$33,263

Year 1 Year 2 Year 3 Year 4 Year 5

$9,000 $9,000 $9,000 $9,000 $9,000

$100,000Discount at effective yield, 11%$100,000 x 0.59345$ 59,345

plus

=$92,608 is the issue price


Amortizing the Bond Premium/Discount

• A premium effectively decreases the annual interest expense for the corporation

• The discount effectively increases the annual interest expense for the issuing corporation

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Amortizing the Bond Premium/Discount

• Two methods available for amortization1)Straight-Line

• Allocates the same amount of discount (or premium) to each interest period

• Acceptable under ASPE2)Effective Interest

• Allocates the discount or premium over the bond term (i.e. amortizes the discount or premium)

• Required under IFRS• The total discount or premium amortized is

the same under both methods19


Straight-Line Method—Discount

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Given:

Face Value = $800,000 Discount = $24,000

Stated Rate = 10% Bond Maturity = 10 years

The annual discount amortization =

$24,00010 years = $2,400

The entry to record the annual discount amortization would be:

Interest Expense 2,400Bonds Payable 2,400


Straight-Line Method—Premium

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Given:

Face Value = $800,000 Premium = $24,000

Stated Rate = 10% Bond Maturity = 10 years

The annual premium amortization =

$24,00010 years = $2,400

The entry to record the annual premium amortization would be

Bonds Payable 2,400Interest Expense 2,400


Effective Interest Method

• Produces a periodic interest expense equal to a constant percentage of the carrying value of the bond– The percentage used is the effective yield

• The amortization of the discount or premium is determined by comparing the interest expense with the interest paid

• Total interest expense over the life of the bond is the same as that using the straight-line method

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Effective Interest Method Calculation: Discount

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Face Value = $100,000 Discount = $7,722Market Rate = 10% Coupon Rate = 8% semi-annualBond Maturity = 5 years

A B C D E F

PeriodCarrying Value

Discount Amortization Interest Paid

Interest Expense

Discount Balance

Carrying Value

= C - DFace Value *

4% =A * 5%Face Value -

E

1 92,278 -614 4,000 4,614 7,108 92,8922 92,892 -645 4,000 4,645 6,464 93,5363 93,536 -677 4,000 4,677 5,787 94,2134 94,213 -711 4,000 4,711 5,076 94,9245 94,924 -746 4,000 4,746 4,330 95,6706 95,670 -784 4,000 4,784 3,546 96,4547 96,454 -823 4,000 4,823 2,724 97,2768 97,276 -864 4,000 4,864 1,860 98,1409 98,140 -907 4,000 4,907 953 99,047

10 99,047 -952 4,000 4,952 0 100,000-7,722 40,000 47,722



• The journal entry to record the bond issuance is:

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Cash 92,278Bonds Payable 92,278



• The journal entry for first semi-annual payment is:

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


Effective Interest Method Calculation: Premium

Face Value = $100,000 Discount = $8,530Market Rate = 6% Coupon Rate = 8% semi-annualBond Maturity = 5 years

A B C D E F

YearCarrying Value

Premium Amortization Interest Paid

Interest Expense

Premium Balance

Carrying Value

= C - DFace Value *

4% =A * 3%Face Value -

E

1 108,530 744 4,000 3,256 7,786 107,7862 107,786 766 4,000 3,234 7,019 107,0193 107,019 789 4,000 3,211 6,230 106,2304 106,230 813 4,000 3,187 5,417 105,4175 105,417 837 4,000 3,163 4,579 104,5796 104,579 863 4,000 3,137 3,717 103,7177 103,717 888 4,000 3,112 2,828 102,8288 102,828 915 4,000 3,085 1,913 101,9139 101,913 943 4,000 3,057 971 100,971

10 100,971 971 4,000 3,029 0 100,0008,530 40,000 31,470



• The journal entry to record the bond issuance is:

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Cash 108,530Bonds Payable 108,530



• The journal entry for first semi-annual payment is:

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Bond Interest Expense 3,256Bonds Payable 744

Cash 4,000


Bonds Issued Between Interest Dates

• Interest for the period between the issue date and the last interest date is paid by the bondholder in addition to the issue price of the bonds

• At the specified interest date, interest is paid for the entire interest period (semi-annual or annual)

• Premium or discount is also amortized from the date of sale

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Non-Market Rates of Interest (Marketable Securities)

• If bond issued for cash, and is marketable, its fair value = cash received by issuer

• Implicit interest rate is the rate that causes the PV (of future cash flows) to equal cash received

• Difference between face amount and PV is the discount– Amortized over life of the bond/note

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Non-Market Rates of Interest (Marketable Securities)

Example• $10,000 3-year zero-interest-bearing

marketable bond issued• Cash received at issuance: $7,722• Implied interest rate is therefore 9%• Discount equal to:

Maturity Value $10,000Less: Cash Received 7,722

$ 2,278

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Non-Market Rates of Interest (Non-Marketable

Instruments)• Non-marketable Instruments

– Cash consideration might not be equal to fair value – there might be additional value being transferred

– Must measure fair value of loan by discounting the cash flows using a market rate of interest

– Any difference is booked to net income unless it meets the definition of an asset or liability

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Instruments) ExampleGiven:• Government gives a 5 year, $100,000 note payable to a

company on January 1st to help it finance the construction of a building

• The note is zero-interest bearing• The market rate is 10%• Recipient company has an additional benefit beyond the

debt financing – the government is forgiving the interest that the company would normally be charged. This is a government grant.

Journalize in issuer’s books

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Instruments) ExampleBooks of the Issuer:

Cash 100,000

Notes Payable 62,092 Building - Government Grant 37,908(PV of 100,000 at 10%, (n=5) = 62,092)

(100,000 – 62,092 = 37,908)• The discount is amortized to interest expense over the

term of note• The government grant is amortized to net income as the

building is depreciated

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Notes Issued for Property, Goods, and Services

• If the issued debt is a marketable security, the value of the transaction would be equal to fair value of the marketable security

• If the issued debt is not a marketable security:– May try to value debt by discounting cash flows at

market rate of interest, or– May use the fair value of the property, goods,

services.

• Any discount or premium amortized over life of the note

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Fair Value Option

• Long-term debt is generally measured at amortized cost however it can also be measured at fair value– IFRS allows the fair value option only if it

results in more relevant information– ASPE allows the fair value option for all

financial instruments

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37


notes payable

• Credit ratings

• Defeasance










issued at par




• Disclosures

• Analysis


of IFRS and ASPE

• Looking ahead


Extinguishment of Debt

• Extinguishment of debt is recorded when:– The debtor pays the creditor, or– The debtor is legally released from paying the

creditor (due to cancellation, expiry etc.)


Repayment before Maturity Date

• When debt is paid out prior to maturity, the amount paid is called the reacquisition price– May be for the full amount of debt or a portion– Includes any call premium and expenses

• At the time of reacquisition all outstanding premiums, discounts, and issue costs are amortized to the date of reacquisition

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Repayment before Maturity Date

• If the net carrying amount of the debt is more than the reacquisition price, this results in a gain from extinguishment

• If the reacquisition price exceeds the net carrying amount of the debt, this results in a loss from extinguishment

• Any gain or loss from the reacquisition is reported with other gains and losses

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Repayment before Maturity Date: Example

Given:• Existing debt: $800,000• Called and cancelled at: $808,000• Unamortized discount: $ 14,400Note: Discount has been amortized up to the date of cancellation of debt. Give the journal entry for the extinguishment.

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Repayment before Maturity Date: Example

Bonds Payable 785,600Loss on Redemption of Bonds 22,400

Cash 808,000

(800,000 – 14,400 = 785,600)

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Troubled Debt Restructurings

• When a creditor grants a favourable concession to a debtor

• Two basic types of transactions1. Settlement of debt at less than carrying value

2. Continuation of debt with modification of terms

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Settlement of Debt

• Old debt, as well as all related discount, premium and issuance costs are removed from books (derecognized)

• A gain is usually recognized since creditor generally makes concessions in settlement of troubled debt (settled at less than carrying value)

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Substantial Modification of Terms

• If debt is continued with substantial modification of terms, the transaction is treated like a settlement– Old liability is derecognized– New (substantially modified) liability is recognized– The difference between the old and new liability is

recorded as a gain

• Modification of terms is substantial if either:– Discounted PV under new terms is at least 10%

different from discounted PV of remaining cash flows under old debt, or

– Old debt is legally discharged and there is a new creditor

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Non-Substantial Modification of Terms

• No gain or loss recognized• New effective interest rate must be found

– Imputed using the rate that equates the carrying value of old debt to cash flows of newly arranged debt

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Defeasance Revisited

• “Legal defeasance” occurs when the creditor no longer has claim on the assets of the original issuer– The debt may be derecognized

• “In-substance defeasance” occurs when the creditor is not aware of the trust arrangement– The debt may not be derecognized

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Off-Balance-Sheet Financing

• Off-balance-sheet financing represents borrowing arrangements that are not recorded

• The amount of debt reported in the statement of financial position does not include such financing arrangements– This is not acceptable and is usually done to improve

certain financial ratios (such as debt-equity ratio)

• In general, increased note disclosure is the accounting profession’s response to off-balance sheet financing

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Non-consolidated entities

• Under present GAAP, a parent company does not have to consolidate an investment in a company where <50% owned and no control

• Therefore, the liabilities of the company would not be reflected on the balance sheet of the parent company, although the parent may be ultimately liable for the debt

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Special Purpose Entities (SPEs) or Variable Interest

Entities (VIEs)• A company may create a special purpose

entity or variable interest entity to perform a special project or function

• This is a concern if SPEs/VIEs are used primarily to disguise debt

• As a general rule, the companies should be consolidated if the company is the main beneficiary of the SPE/VIE

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Operating Leases

• Another way to reduce a company’s debt is to lease rather than own

• If a lease is considered an operating lease, the company would need to record rent expense each period with note disclosure (further covered in chapter 20)

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52


notes payable

• Credit ratings

• Defeasance










issued at par




• Disclosures

• Analysis


of IFRS and ASPE

• Looking ahead


Presentation of Long-Term Debt

• Current versus long-term– Debt to be refinanced treated as current

unless specific refinancing conditions met

• Debt versus equity– Dependent on nature of the instrument

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Disclosures

• Include:– Nature of the liability– Maturity date– Interest rate– Call provision– Conversion privilege– Any restrictions imposed– Assets designated or pledged as security

• Any assets pledged as security for the debt should be shown in the assets section of the statement of financial position

• Fair value of the long-term debt should also be disclosed54


Analysis

Debt to Total Assets: Total debt Total assets

• Level or percentage of assets that is financed through debt

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Times Interest Earned:

Income before income taxes and interestInterest expense

• Measures ability to meet interest payments



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notes payable

• Credit ratings

• Defeasance










issued at par




• Disclosures

• Analysis


of IFRS and ASPE

• Looking ahead


Looking Ahead

• There are several current projects by IASB and FASB that could impact future accounting standards for long-term debt:– Financial instruments project– Financial instruments with the characteristics

of equity– Conceptual framework project

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TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Lisa Harvey, CPA, CA Rotman School of Management, University of Toronto 14 CHAPTER 14 Long-Term.

Documents

longterm debt obligations

revenue bonds

common type of longterm

maturity convertible

stocks serial bonds

current owner secured

notes payable similar

future date