Financial Accounting

Chapter 4: Long Term Liabilities

Typical Non-Current Liabilities

1. Bonds payable
2. Notes / Loans payable
3. Deferred tax liability
4. Pensions payable
5. Finance lease payable
Not all bonds payable or bank loans payable are long-term in nature. Bond and
loan repayments that are due within a year are classified as current liabilities
and the rest are reported as long-term.
Bonds Payable

Long-term finance is usually obtained by issuing bonds. Bonds are issued

by governments, corporations and other entities.
A bond is a debt instrument, generally issued to many investors, that
requires future repayment of the original amount at a fixed date, as well
as periodic interest payments during the intervening period.
Bonds are transferrable so individual bondholders may sell their bonds to
other investors at any time.
Bonds Payable - Characteristics

1. Par value / Face value / Nominal value

2. Coupon Rate / Nominal Rate / Interest Rate
3. Maturity
4. Credit Quality
5. Embedded Options
Bonds Payable - Characteristics

Par value / Face value / Nominal value:

The par value of a bond is the amount at which the issuing entity will
redeem the bond certificate on the maturity date.
The par value is also the amount upon which the entity calculates the
interest that it owes to investors.
Thus, if the stated interest rate on a bond is 10% and the bond par value
is Rs.1,000, then the issuing entity must pay Rs.100 every year until it
redeems the bond.
Bonds Payable - Characteristics

Coupon Rate / Nominal Rate / Interest Rate

Coupon is the interest rate the issuer pays to the bondholder. It is usually expressed
as a percentage of the par value.
If a bond pays a coupon of 10% and its par value is Rs.10,000, its annual interest
would be Rs.10,000*10% = Rs.1000.
Suppose the market value of the bond changes to Rs.20,000.
This would have no effect on the coupon rate which is still 10% of the par value
(Rs.10,000) of the bond.
However, the bondholders (the lenders) are now receiving Rs.1,000 on an investment
worth Rs.20,000. This is a return of 5%. This is known as the yield on the bond.
Bonds Payable - Characteristics

Coupon Rate / Nominal Rate / Interest Rate

Rates that remain as a fixed percentage of the par value are considered
as Fixed-rate bond.
Interest rate can also vary with a money market index, such as LIBOR.
Such bonds are called floating-rate bonds.
Bonds Payable - Characteristics

Maturity
Maturity is the date on which the principal amount of a bond or other debt
instrument becomes due and is reimbursed back to the investor and
thereafter the interest payments stop.
Bonds Payable - Characteristics

Credit Quality
Credit quality informs investors of a bond or bond portfolio's credit
worthiness or risk of default. A company or security’s credit quality may
also be known as its “bond rating."
There are many rating agencies that rate the bonds according to the risk
factor of the bonds. For example,
International rating agencies are Moody’s, S&P.
In Pakistan PACRA and VIS rate the bonds of companies of Pakistan.
Bonds Payable - Characteristics

Credit Quality
Bond risk increases due to the following reasons.
• Excessive borrowing or debt
• Operating losses
• Small size of business
• Large variations in income
• Country & foreign exchange rate risk
Bonds Payable - Characteristics

Embedded Options
In the broadest terms, embedded options are components built into the
structure of a financial security that provide the option of one of the
parties to exercise some action under certain conditions.
Each investor has a unique set of income needs, risk tolerances, tax
rates, liquidity needs and time horizons — embedded options provide a
variety of solutions to fit all participants.
Bonds Payable - Characteristics

Embedded Options: Examples

Call option
An option that allows the issuer to buy back or redeem bonds at some time in the
future before the maturity date. Bonds that have a call option are referred to as
callable bonds.
Put option
Some bonds give the holder the right to force the issuer to repay the bond before the
maturity date. These are referred to as retractable or putable bonds.
Conversion option
The bond holder has the option to convert that bond into stock of company. Such
bonds are called convertible bonds.
Bonds Payable - Classification

• Secured and Unsecured bonds

• Fixed rate bonds, Floating rate bonds and Zero-coupon bonds
• Registered bonds and Bearer (Coupon) bonds
• Term, Serial, and Callable bonds
• Perpetual bonds
• Convertible bonds
• High yield bonds or junk bonds
Bonds Payable – Valuation

Investment community values a bond at the present value of its expected

future cash flows, which consist of
a) Interest payable and
b) Principal.
Bonds Payable – Valuation

How do you calculate the amount of interest that is actually paid to the
bondholder each period?
Interest payable = Stated Coupon Rate x Face Value of the bond

How do you calculate the amount of interest that is actually recorded as

interest expense by the issuer of the bonds?
Interest expense = Effective rate x Carrying amount of the bond
Bonds Payable – Valuation

Interest Rate
Stated, coupon, or nominal rate
Rate written in the terms of the bond indenture. Bond issuer sets this rate.
Stated as a percentage of bond face value (par).
Effective Interest Rate
The effective interest rate is the true rate of interest earned by the bondholders.
It could also be referred to as the market interest rate, the yield to maturity,
the discount rate, the internal rate of return, the annual percentage rate
(APR), and the targeted or required interest rate.
Bonds Payable – Valuation

Contractual interest rate is the rate applied to the face (par) value to
arrive at the interest paid in a year. The market interest rate is the rate
investors demand for loaning funds to the corporation. When the
contractual interest rate and the market interest rate are the same,
bonds sell at face value (par value).
However, market interest rates change daily. The type of bond issued,
the state of the economy, current industry conditions, and the
company’s performance all affect market interest rates. As a result,
contractual and market interest rates often differ. To make bonds
salable when the two rates differ, bonds sell below or above face value.
Bonds Payable – Valuation

Assume Nominal Rate of 8%

Market Interest Bonds Sold At

6% Premium

8% Par Value

10% Discount
Bonds Payable – Valuation (At Par)

Santos Company issues R$100,000 in bonds dated January 1, 2015, due

in five years with 9 percent interest payable annually on January 1. At the
time of issue, the market rate for such bonds is 9 percent.
Bonds Payable – Valuation

Initial Recognition: Fair Value less transaction cost

Subsequent Recognition: Amortized cost using Effective Interest Method
The amortised cost of a financial liability is calculated as:
• amount initially recognised as a liability (initial cost); plus
• interest expense recognised (using the effective rate); less
• interest actually paid (cash paid).
Interest expense is measured using the effective rate. This is the rate that
matches the amount borrowed with the discounted future cash flows paid.
 Bonds Payable – Valuation (At Par)

Santos Company issues R$100,000 in bonds dated January 1, 2015, due

in five years with 9 percent interest payable annually on January 1. At the
time of issue, the market rate for such bonds is 9 percent.

PV of face value = Future value / (1+i)^n = PV of interest payments= [1-((1+i)^(-n)) ]/i

100000/ (1.09)^5 = 64993 i = market interest rate
i = market interest rate n = maturity period of bond
n = maturity period of bond
Bonds Payable – Valuation (At Par)

Journal entry on date of issue, Jan. 1, 2015.

Cash 100,000
Bonds payable 100,000

Journal entry to record accrued interest at Dec. 31, 2015.

Interest expense 9,000
Interest payable 9,000

Journal entry to record first payment on Jan. 1, 2016.

Interest payable 9,000
Cash 9,000
Bonds Payable – Valuation (At Discount)

Assuming now that Santos issues R$100,000 in bonds, due in five years
with 9 percent interest payable annually at year-end. At the time of issue,
the market rate for such bonds is 11 percent.

PV = FV / (1+i)^n = 100000/ (1.11)^5 = 59345

i = market interest rate
n = maturity period of bond
Bonds Payable – Valuation (At Discount)

Journal entry on date of issue, Jan. 1, 2015.

Cash 92,608
Bonds payable 92,608

Journal entry to record accrued interest at Dec. 31, 2015.

Interest expense 10,187 (92,608 *11%)
Interest payable 9,000 (100,000 * 9%)
Bonds Payable 1,187 (amortization of discount)

Journal entry to record first payment on Jan. 1, 2016.

Interest payable 9,000
Cash 9,000
Bonds Payable – Valuation

Illustration: Evermaster Corporation issued €100,000 of 8% term bonds

on January 1, 2015, due on January 1, 2020, with interest payable each
July 1 and January 1. Investors require an effective-interest rate of 10%.
Calculate the bond proceeds.
.
Bonds Payable – Valuation (At Discount)

D D = D(n-1) – A + B
A B C=A-B OR
D = D(n-1) + C
Bonds Payable – Valuation (At Discount)

Journal entry on date of issue, Jan. 1, 2015.

Cash 92,278
Bonds Payable 92,278
Bonds Payable – Valuation (At Discount)

Journal entry to record first payment and amortization of the discount on July
1, 2015.
Interest expense 4,614
Bonds payable 614
Cash 4,000
Bonds Payable – Valuation (At Discount)

Journal entry to record accrued interest and amortization of the discount on

Dec. 31, 2015.
Interest expense 4,645
Interest payable 4,000
Bonds payable 645
Bonds Payable – Valuation (At Premium)

Illustration: Evermaster Corporation issued €100,000 of 8% term bonds

on January 1, 2015, due on January 1, 2020, with interest payable each
July 1 and January 1. Investors require an effective-interest rate of 6%.
Calculate the bond proceeds.
.
Bonds Payable – Valuation (At Premium)

D
B C=A-B D = D(n-1) – A + B
A
OR
D = D(n-1) - C
Bonds Payable – Valuation (At Premium)

Journal entry on date of issue, Jan. 1, 2015.

Cash 108,530
Bonds payable 108,530
Bonds Payable – Valuation (At Premium)

Journal entry to record first payment and amortization of the premium on

July 1, 2015.
Interest expense 3,256
Bonds payable 744
Cash 4,000
Bonds Payable – Valuation (Accrued Interest)

Accrued Interest
What happens if Evermaster prepares financial statements at the end of
February 2015?
In this case, the company prorates the premium by the appropriate
number of months to arrive at the proper interest expense, as follows.
Bonds Payable – Valuation

Accrued Interest

Evermaster records this accrual as follows:

Interest expense 1,085.33
Bonds payable 248.00
Interest payable 1,333.33
Notes Payable

Accounting is Similar to Bonds

• A note is valued at the present value of its future interest and principal
cash flows.
• Company amortizes any discount or premium over the life of the note.
Notes Payable – Valuation (Issued at Face Value)

Coldwell, Inc. issued a €100,000, 4-year, 10% note at face value to Flint Hills
Bank on January 1, 2015, and received €100,000 cash. The note requires
annual interest payments each December 31. Prepare Coldwell’s journal
entries to record
(a) the issuance of the note and
(b) the December 31 interest payment.

(a) Cash 100,000

Notes payable 100,000

(b) Interest expense 10,000

Cash 10,000
(€100,000 x 10% = €10,000)
Notes Payable – Valuation

Zero-Interest-Bearing Notes
Issuing company records the difference between the face value and the
present value (cash received) as
• a discount and
• amortizes that amount to interest expense over the life of the note.
Notes Payable – Valuation (Issued at Discount)

Illustration (zero-interest bearing note): Turtle Cove Company issued the

three-year, $10,000, zero-interest-bearing note to Jeremiah Company.
The implicit rate that equated the total cash to be paid ($10,000 at
maturity) to the present value of the future cash flows ($7,721.80 cash
proceeds at date of issuance) was 9 percent.
Turtle Cove records issuance of the note as follows.

Cash 7,721.80

Notes Payable 7,721.80

Notes Payable – Valuation (Issued at Discount)
Notes Payable – Valuation (Issued at Discount)

Turtle Cove records interest expense for year 1 as follows:

Interest Expense 694.96 ($7,721.80 x 9%)

Notes Payable 694.96
Notes Payable – Valuation (Issued at Discount)

Illustration (interest bearing note): Marie Co. issued for cash a €10,000,
three-year note bearing interest at 10 percent to Morgan Corp. The
market rate of interest for a note of similar risk is 12 percent.
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 face
value. That is, the note is exchanged at a discount.
Notes Payable – Valuation (Issued at Discount)

Illustration (interest bearing note): Marie Co. issued for cash a €10,000,
three-year note bearing interest at 10 percent to Morgan Corp. The
market rate of interest for a note of similar risk is 12 percent.
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 face
value. That is, the note is exchanged at a discount.
Marie Co. records the issuance of the note as follows:

Cash 9,520
Notes Payable 9,520
Notes Payable – Valuation (Issued at Discount)
Notes Payable – Valuation (Issued at Discount)

Marie Co. records the following entry at the end of year 1:

Interest Expense 1,142
Notes Payable 142
Cash 1,000
Non-Current Liabilities – Redemption

Redeeming loan at maturity

Payable XXX
Cash XXX
Non-Current Liabilities – Redemption

Special issues related to extinguishment of non – current liability

a) Extinguishment with cash before maturity,
b) Extinguishment by transferring assets or securities, and
c) Extinguishment with modification of terms.
Non-Current Liabilities – Redemption

Extinguishment with cash before maturity

• Net carrying amount > Reacquisition price = Gain
• Net carrying amount < Reacquisition price = Loss
• At time of reacquisition, unamortized premium or discount must be
amortized up to the reacquisition date.
 Non-Current Liabilities – Redemption
Illustration (Extinguishment with cash before maturity): Evermaster
bonds issued at a discount on January 1, 2015. These bonds are due in
five years. The bonds have a par value of €100,000, a coupon rate of 8%
paid semiannually, and were sold to yield 10%.
Two years after the issue date on January 1, 2017, Evermaster calls the
entire issue at 101 and cancels it.
Non-Current Liabilities – Redemption

Illustration (Extinguishment with cash before maturity): Evermaster

bonds issued at a discount on January 1, 2015. These bonds are due in
five years. The bonds have a par value of €100,000, a coupon rate of 8%
paid semiannually, and were sold to yield 10%.
Two years after the issue date on January 1, 2017, Evermaster calls the
entire issue at 101 and cancels it.
Non-Current Liabilities – Redemption

Evermaster records the reacquisition and cancellation of the bonds as

follows:

Bonds Payable 94,925

Loss on Extinguishment of Bonds 6,075
Cash 101,000
Non-Current Liabilities – Redemption

Extinguishment by Exchanging Assets or Securities

• Creditor should account for the non-cash assets or equity interest
received at their fair value.
• Issuer (Debtor) recognizes a gain equal to the excess of the carrying
amount of the payable over the fair value of the assets or equity
transferred (gain).
Non-Current Liabilities – Redemption

Illustration (Extinguishment by Exchanging Assets): Hamburg Bank loaned

€20,000,000 to Bonn Mortgage Company. Bonn, in turn, invested these monies in
residential apartment buildings. However, because of low occupancy rates, it cannot
meet its loan obligations.
Hamburg Bank agrees to accept from Bonn Mortgage real estate with a fair value of
€16,000,000 in full settlement of the €20,000,000 loan obligation.
The real estate has a carrying value of €21,000,000 on the books of Bonn Mortgage.
Bonn (debtor) records this transaction as follows.

Note Payable (to Hamburg Bank) 20,000,000

Loss on Disposal of Real Estate 5,000,000
Real Estate 21,000,000
Gain on Extinguishment of Debt 4,000,000
Non-Current Liabilities – Redemption

Illustration (Extinguishment by Exchanging Securities): Now assume that Hamburg

Bank agrees to accept from Bonn Mortgage 320,000 ordinary shares (€10 par) that
have a fair value of €16,000,000, in full settlement of the €20,000,000 loan obligation.
Bonn Mortgage (debtor) records this transaction as follows:

Notes Payable (to Hamburg Bank) 20,000,000

Share Capital—Ordinary 3,200,000
Share Premium—Ordinary 12,800,000
Gain on Extinguishment of Debt 4,000,000
Non-Current Liabilities – Redemption

Extinguishment by Modification of Terms

Creditor may offer 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.
Non-Current Liabilities – Redemption

Illustration (Extinguishment by Modification of Terms): On December 31,

2015, Morgan National Bank enters into a debt modification agreement
with Resorts Development Company. The bank 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, 2015, to December
31, 2019; and
• Reducing the interest rate from the historical effective rate of 12
percent to 8 percent. Given Resorts Development’s financial distress,
its market-based borrowing rate is 15 percent.
Non-Current Liabilities – Redemption

IFRS requires the modification to be accounted for as an extinguishment

of the old note and issuance of the new note, measured at fair value.
Non-Current Liabilities – Redemption

The gain on the modification is ¥3,298,664, which is the difference

between the prior carrying value (¥10,500,000) and the fair value of the
restructured note.
Given this information, Resorts Development makes the following entry to
record the modification:

Note Payable (old) 10,500,000

Gain on Extinguishment of Debt 3,298,664
Note Payable (new) 7,201,336
Non-Current Liabilities – Redemption

Amortization schedule for the new note.

Non-Current Liabilities – Presentation

Note disclosures generally indicate the

• nature of the liabilities,
• maturity dates,
• interest rates,
• call provisions,
• conversion privileges,
• restrictions imposed by the creditors, and
• assets designated or pledged as security.
Must disclose future payments for sinking fund requirements and maturity
amounts of long-term debt during each of the next five years.