CHAPTER 14 LONG TERM LIABILITIES Overview This chapter continues the presentation of liabilities Specifically the discussion focuses on the accounting treatment of long term liabilities Long term notes and bonds are discussed as well as the extinguishment of debt and troubled debt restructuring Learning Objectives 1 Identify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt 2 Account for bonds issued at par at a discount or at a premium recording interest at the effective rate or by the straight line method 3 Characterize the accounting treatment of notes including installment notes issued for cash or for noncash consideration 4 Describe the disclosures appropriate to long term debt in its various forms 5 Record the early extinguishment of debt and its conversion into equity securities 6 Understand the option to report liabilities at their fair values 7 Discuss the primary differences between U S GAAP and IFRS with respect to accounting for bonds and long term notes 14 1 LONG TERM DEBT Signifies creditors interest in a company s assets Requires the future payment of cash in specified or estimated amounts at specified or projected dates As time passes interest accrues on debt Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period Reported at present value of its related cash flows principal and or interest payments discounted at the effective rate of interest at issuance 14 2 BONDS Debenture bond secured only by the full faith and credit of the issuing corporation No specific assets are pledged as security Mortgage bond backed by a lien on specified real estate owned by the issuer Subordinated debenture not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied Registered bond interest checks are mailed directly to the owner who is registered with the issuing company Callable or redeemable bonds the call feature allows the issuing company to buy back or call outstanding bonds from bondholders before their scheduled maturity date Serial bonds retired in installments over all or part of the life of the issue Each bond has its own specified maturity date Convertible bonds retired as a consequence of bondholders choosing to convert them into shares of stock 14 3 BONDS SOLD AT FACE AMOUNT On January 1 2011 Masterwear Industries issued 700 000 of 12 bonds Interest of 42 000 is payable semiannually on June 30 and December 31 The bonds mature in three years an unrealistically short maturity to shorten the illustration The entire bond issue was sold in a private placement to United Intergroup Inc at face amount At Issuance January 1 Masterwear Issuer Cash Bonds payable face amount 700 000 United Investor Investment in bonds face amount Cash 700 000 14 4 700 000 700 000 DETERMINING THE SELLING PRICE A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity Illustration On January 1 2011 Masterwear Industries issued 700 000 of 12 bonds dated January 1 Interest is payable semiannually on June 30 and December 31 The bonds mature in three years The market yield for bonds of similar risk and maturity is 14 The entire bond issue was purchased by United Intergroup Inc Present value price of the bonds Interest 42 000 x 4 76654 Principal 700 000 x 0 66634 Present value price of the bonds Present Values 200 195 466 438 666 633 present value of an ordinary annuity of 1 n 6 i 7 present value of 1 n 6 i 7 Note Because interest is paid semiannually the present value calculations use a the semiannual stated rate 6 b the semiannual market rate 7 and c 6 3 x 2 semi annual periods 14 5 JOURNAL ENTRIES AT ISSUANCE BONDS SOLD AT DISCOUNT Masterwear Issuer Cash price calculated above Discount on bonds payable difference Bonds payable face amount United Investor Investment in bonds face amount Discount on bond investment difference Cash price calculated above 14 6 666 633 33 367 700 000 700 000 33 367 666 633 DETERMINING INTEREST EFFECTIVE INTEREST METHOD Interest accrues on an outstanding debt at a constant percentage of the debt each period Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt during the interest period Continuing the previous example interest recorded as expense to the issuer and revenue to the investor for the first six month interest period is 46 664 666 633 Outstanding Balance x 14 2 Effective Rate 46 664 Effective Interest However the bond indenture calls for semiannual interest payments of only 42 000 the stated rate 6 times the face value 700 000 The difference 4 664 increases the liability and is reflected as a reduction in the discount a valuation account 14 7 CHANGE IN DEBT WHEN EFFECTIVE INTEREST EXCEEDS CASH PAID The unpaid portion of the effective interest increases the existing liability ACCOUNT BALANCES January 1 Interest accrued at 7 Portion of interest paid June 30 OUTSTANDING BALANCE 666 633 46 664 42 000 671 297 Bonds payable Discount on face value bonds 700 000 less 33 367 700 000 less 4 664 28 703 Interest accrues on the outstanding debt at the effective rate Interest paid is the amount specified in the bond indenture the stated rate times the face value 14 8 JOURNAL ENTRIES THE INTEREST METHOD The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period At the First Interest Date June 30 Masterwear Issuer Interest expense market rate x outstanding bal 46 664 Discount on bonds payable difference 4 664 Cash stated rate x face amount 42 000 United Investor Cash stated rate x face amount 42 000 Discount on bond investment difference 4 664 Interest revenue market rate x outstanding bal 46 664 14 9 AMORTIZATION SCHEDULE DISCOUNT Since less cash is paid each period than the effective interest the unpaid difference increases the outstanding balance of the debt Cash Interest Effective Interest Increase in Balance 6 x Face Value 7 x Outstanding Debt Discount Reduction 1 01 11 6 30 11 12 31 11 6 30 12 12 30 12 6 30 13 12 30 13 42 000 42 000 42 000 42 000 42 000 42 000 252 000 07 666 633 07 671 297 07 676 288 07 681 628 07 687 342 07 693 456 46 664 46 991 47 340 47 714 48 114 48 544 4 664 4 991 5 340 5 714 6 114 6 544 285 367 33 367 rounded 14 10 Outstanding Balance 666 633 671 297 676 288 681 628 687