Chapter Two: Non-Current Liabilities

Learning Objectives:
1. Describe the formal procedures associated with issuing long-term debt.
2. Identify various types of bond issues.
3. Describe the accounting valuation for bonds at date of issuance.
4. Apply the methods of bond discount and premium amortization.
5. Explain the accounting for long-term notes payable.
6. Describe the accounting for the extinguishment of non-current liabilities.
7. Describe the accounting for the fair value option.
8. Explain the reporting of off-balance-sheet financing arrangements.
9. Indicate how to present and analyze non-current liabilities.
2.1Nature of long-term debt
Non-current liability (Long-term debt) consists of probable future sacrifices of economic
benefits arising from present obligations that are not payable within a year or the operating cycle
of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages
payable, pension liabilities, and lease liabilities are examples of long term liabilities.

A corporation, per its bylaws, usually requires approval by the board of directors and the
stockholders before bonds or notes can be issued. The same holds true for other types of long-
term debt arrangements.

Generally, long-term debt has various covenants or restrictions that protect both lenders and
borrowers. The indenture or agreement often includes the amounts authorized to be issued,
interest rate, due date(s), call provisions, property pledged as security, sinking fund
requirements, working capital and dividend restrictions, and limitations concerning the
assumption of additional debt. Companies should describe these features in the body of the
financial statements or the notes if important for a complete understanding of the financial
position and the results of operations.

Although it would seem that these covenants provide adequate protection to the long-term debt
holder, many bondholders suffer considerable losses when companies add more debt to the
capital structure. Such a loss in value occurs because the additional debt added to the capital
structure increases the likelihood of default. Although covenants protect bondholders, they can
still suffer losses when debt levels get too high.

2.2 Types of Bonds

There are different types of bonds. Some of them are presented as follows:
1. Secured and Unsecured bonds: Secured bonds are backed by a pledge of 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” (high-risk bonds issued by
companies with a weak financial position) is unsecured and also very risky, and therefore
pays a high interest rate. Companies often use these bonds to finance leveraged buyouts.
2. Term, Serial bonds, and Callable bonds: Bond issues that mature on a single date are called
term bonds; issues that mature in installments are called serial bonds. Callable bonds
give the issuer the right to call and retire the bonds prior to maturity.
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 3. Convertible, Commodity-backed, and Deep-discount bonds: If bonds are convertible into
other securities of the corporation for a specified time after issuance, they are convertible
bonds. Two types of bonds have been developed in an attempt to attract capital in a tight
money market—commodity-backed bonds and deep-discount bonds. Commodity-
backed bonds (also called asset-linked bonds) are redeemable in measures of a
commodity, such as barrels of oil, tons of coal, or ounces of rare metal. Deep-discount
bonds also referred to as zero interest debenture bonds, bonds that pay exceptionally
low rate of interest. They are sold at a discount that provides the buyer’s total interest
payoff at maturity.
4. Registered and Bearer (Coupon) bonds: Bonds issued in the name of the owner are
registered bonds and require surrender of the certificate and issuance of a new certificate
to complete a sale. A bearer or coupon bond, however, is not recorded in the name of
the owner and may be transferred from one owner to another by mere delivery.
5. Income and Revenue bonds: Income bonds pay no interest unless the issuing company is
profitable. Revenue bonds, so called because the interest on them is paid from specified
revenue sources, are most frequently issued by airports, school districts, counties, toll-
road authorities, and governmental bodies.
Valuation of Bonds Payable
Issuance and marketing of bonds to the public:
 Usually takes weeks or months.
 Issuing company must
► Arrange for underwriters.
► Obtain regulatory approval of the bond issue, undergo audits, and issue a
prospectus.
► Have bond certificates printed.
Selling price of a bond issue is set by the
 supply and demand of buyers and sellers,
 relative risk,
 market conditions, and
 State of the economy.
Investment community values a bond at the present value of its expected future cash flows,
which consist of (1) interest and (2) principal.
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).
 Market rate or effective yield = Rate that provides an acceptable return
commensurate with the issuer’s risk.
 Rate of interest actually earned by the bondholders.

How do you calculate the amount of interest that is actually paid to the bondholder each period?
(Stated rate x Face Value of the bond)

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How do you calculate the amount of interest that is actually recorded as interest expense by the
issuer of the bonds?
(Market rate x Carrying Value of the bond)
Assume Stated Rate of 8%
If market interest is 6% bonds sold at premium, market interest is 8% bonds sold at discount and
market interest is 10% bonds sold at discount.
Bonds Issued at Par
Illustration: Santos Company issues $100,000 in bonds dated January 1, 2011, 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.

Journal entry on date of issue, Jan. 1, 2011.

Cash 100,000
Bonds payable 100,000
Journal entry to record accrued interest at Dec. 31, 2011.
Bond interest expense 9,000
Bond interest payable 9,000
Journal entry to record first payment on Jan. 1, 2012.
Bond interest payable 9,000
Cash 9,000
Bonds Issued at a Discount
Illustration: Assuming now that Santos issues $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.

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Journal entry on date of issue, Jan. 1, 2011.

Cash 92,608
Bonds payable 92,608
Journal entry to record accrued interest at Dec. 31, 2011.
Bond interest expense 10,187
Bond interest payable 9,000
Bonds payable 1,187
Journal entry to record first payment on Jan. 1, 2012.
Bond interest payable 9,000
Cash 9,000
When bonds sell at less than face value:
► Investors demand a rate of interest higher than stated rate.
► Usually occurs because investors can earn a higher rate on alternative
investments of equal risk.
► Cannot change stated rate so investors refuse to pay face value for the bonds.
► Investors receive interest at the stated rate computed on the face value, but they
actually earn at an effective rate because they paid less than face value for the
bonds.
2.3 Accounting for term bonds
Effective-Interest Method of Amortization of term bond
Bond issued at a discount - amount paid at maturity is more than the issue amount.
Bonds issued at a premium - company pays less at maturity relative to the issue price.
Adjustment to the cost is recorded as bond interest expense over the life of the bonds through a
process called amortization.
Required procedure for amortization is the effective-interest method (also called present value
amortization).
Effective-interest method produces a periodic interest expense equal to a constant percentage
of the carrying value of the bonds.

Bonds Issued at a Discount

Illustration: Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2011,
due on January 1, 2016, with interest payable each July 1 and January 1. Investors require an
effective-interest rate of 10%. Calculate the bond proceeds.

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Journal entry on date of issue, Jan. 1, 2011.
Cash 92,278
Bonds payable 92,278
Journal entry to record first payment and amortization of the discount on July 1, 2011.
Bond interest expense 4,614
Bonds payable 614
Cash 4,000
Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2011
Bond interest expense 4,645
Bond interest payable 4,000
Bonds payable 645
Bonds Issued at a Premium
Illustration: Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2011,
due on January 1, 2016, with interest payable each July 1 and January 1. Investors require an
effective-interest rate of 6%. Calculate the bond proceeds.

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Journal entry on date of issue, Jan. 1, 2011.
Cash 108,530
Bonds payable 108,530
Journal entry to record first payment and amortization of the premium on July 1, 2011.
Bond interest expense 3,256
Bonds payable 744
Cash 4,000
Accrued Interest
What happens if Evermaster prepares financial statements at the end of February 2011? In this
case, the company prorates the premium by the appropriate number of months to arrive at the
proper interest expense, as follows.

Evermaster records this accrual as follows.

Bond interest expense 1,085.33
Bonds payable 248.00
Bond interest payable 1,333.33
Bonds Issued between Interest Dates
Bond investors will pay the seller the interest accrued from the last interest payment date to the
date of issue. On the next semiannual interest payment date, bond investors will receive the full
six months’ interest payment.
Bonds Issued at Par
Illustration: Assume Evermaster issued its five-year bonds, dated January 1, 2011, on May 1,
2011, at par ($100,000). Evermaster records the issuance of the bonds between interest dates as
follows. ($100,000 x .08 x 4/12) = $2,667

Cash 100,000
Bonds payable 100,000
Cash 2,667
Bond interest expense 2,667
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Bonds Issued at Par
On July 1, 2011, two months after the date of purchase, Evermaster pays the investors six
months’ interest, by making the following entry. ($100,000 x .08 x 1/2) = $4,000
Bond interest expense 4,000
Cash 4,000

Bonds Issued at Discount or Premium

Illustration: Assume that the Evermaster 8% bonds were issued on May 1, 2011, to yield 6%.
Thus, the bonds are issued at a premium price of $108,039. Evermaster records the issuance of
the bonds between interest dates as follows.
Cash 108,039
Bonds payable 108,039
Cash 2,667
Bond interest expense 2,667
Bonds Issued at Discount or Premium
Evermaster then determines interest expense from the date of sale (May 1, 2011), not from the
date of the bonds (January 1, 2011).

The premium amortization of the bonds is also for only two months

Evermaster therefore makes the following entries on July 1, 2011, to record the interest payment and
the premium amortization.

Bond interest expense 4,000

Cash 4,000
Bonds payable 253
Bond interest expense 253
2.4 Accounting for serial bonds
Effective-Interest Method of Amortization of serial bonds
Serial bond provides for payment of the principal in periodic installments. Serial bonds have the
advantage of gearing the issuer’s debt repayment to its periodic cash inflow from operations.
The proceeds of a serial bond issue are the present value of the series of principal payments plus
the present value of the interest payments, all at the effective interest rate equals the proceeds
received for the bonds.
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At this point the question arises: is there any single interest rate applicable to a serial bond issue?
We often refer loosely to the rate of interest, when in fact in the market at any one time there are
several interest rates, depending on the terms, nature, and length of the bond contract offered.
In a specific serial bond issue, the terms of all bonds in the issue are the same except for the
differences in maturity. However, because short-term interest rates often differ from long-term
rates, it is likely that each maturity will sell at a different yield rate, so that there will be a
different discount or premium relating to each maturity.
In many cases, high degree of precision in accounting for serial bond issues is not possible
because the yield rate for each maturity is not known. Underwriters may bid on an entire serial
bond issue on the basis of an average yield rate and may not disclose the particular yield rate for
each maturity that was used to determine the bid price. In this situation we may have to assume
that the same yield rate applies to all maturities in the issue, and proceed accordingly.
If interest method is to be used in according for serial bond interest expense, the procedure is
similar to the illustrated in connection with term bonds.
A variation of the straight-line method, known as the bonds outstanding method, results in a
decreasing amount of premium or discount amortization each accounting period proportionate to
the decrease in the amount of outstanding serial bonds.
Illustration: Assume that in early January, 2003; a company issued Br. 500,000 of ten-year,
10% serial bonds, to be repaid in the amount of Br. 50,000 each year. Assume that interest
payments are made annually and that the bond issue costs were Br. 25000. As to the yield rate,
assume the following two cases: Case 1: 9% and Case 2: 11%
Required
1. Present the journal entry to record the bond issue cost.
2. Compute the proceeds received on the bonds under case1.
3. Compute the amount of bond premium at the time of issuance under case 1.
4. Compute the proceeds received on the bonds under case 2.
5. Compute the amount of bond discount at the time of issuance under case 2.
6. Present the journal entry to record the issuance of the bonds under case 1.
7. Present the journal entry to record the issuance of the bonds under case 2.
8. Prepare premium amortization table for the serial bonds using the interest method.
9. Prepare premium amortization table for the serial bonds using the bonds outstanding method.
10. Prepare the discount amortization table for the serial bonds using the interest method.
11. Prepare discount amortization table for the serial bonds using the bonds outstanding method.
12. Present the journal entry for the amortization of the bond issue cost for 2003.
13. Present the journal entry to record the retirement of the first serial bond and the payment of
the first interest.
a) Under case 1 using the interest method
b) Under case 1 using the bond outstanding method
c) Under case 2 using the interest method
d) Under case 2 using the bond outstanding method
Solution
1. To record bond issue costs
Unamortized bond issue costs 25,000
Cash 25,000

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1. Proceeds under case 1
Interest due
(10% Total Discounting
End of principal left) Principal due amount factor (9%) Present
due value
2003 Br. 50,000 Br. 50,000 Br.100,000 0.917 Br. 91,700
2004 45,000 50,000 95,000 0.842 79,990
2005 40,000 50,000 90,000 0.772 69,480
2006 35,000 50,000 85,000 0.708 60,180
2007 30,000 50,000 80,000 0.650 52,000
2008 25,000 50,000 75,000 0.596 44,700
2009 20,000 50,000 70,000 0.547 38,290
2010 15,000 50,000 65,000 0.502 32,630
2011 10,000 50,000 60,000 0.460 27,600
2012 5,000 50,000 55,000 0.422 23,210
Totals Br. 275,000 Br. 500,000 Br.775,000 Br. 519,780
Proceeds = Br. 519,780
2. Amount of bond premium at the time of issuance, case 1
Total proceeds Br. 519,780
Face value 500,000
Premium Br. 19,780
3. Proceeds under case 2

Total amount due Discounting factor (11%)

End of Present value
2003 Br. 100,000 0.901 Br. 90,100
2004 95,000 0.812 77,140
2005 90,000 0.731 65,790
2006 85,000 0.659 56,015
2007 80,000 0.593 47,440
2008 75,000 0.535 40,125
2009 70,000 0.482 33,740
2010 65,000 0.434 28,210
2011 60,000 0.391 23,460
2012 55,000 0.352 19,360
Totals Br. 775,000 Br. 481,380
Proceeds = Br. 481,380
5. Amount of discount, case 2
Face value Br. 500,000
Proceeds 481,380
Discount Br. 18,620
6. Journal entry to record issuance under case 1
Cash 519,780
Bonds Payable 500,000
Premium on bonds payable 19,780
7. Journal entry to record issuance under case 2

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 Cash 481,380
Discount on bonds payable 18,620
Bonds payable 500,000
7 Premium amortization table (interest method)
Year Interest Interest Premium Bond Principal Carrying amount
(A) Payment expense Amortization Premium Balance (G)= (E)+(F)
(B)= 10%*(F) (C)=9%*(G) (D)= (B)-(C) Balance (F)
(E)= (E)-(D)
Issue - - - Br. 19,780 500,000 Br. 519,780
2003 Br. 50,000 Br. 46,780 Br. 3,220 16,560 450,000 466,560
2004 45,000 41,990 3,010 13,550 400,000 413,550
2005 40,000 37,220 2,780 10,770 350,000 360,770
2006 35,000 32,469 2,531 8,239 300,000 308,239
2007 30,000 27,742 2,258 5,981 250,000 255,981
2008 25,000 23,038 1,962 4,019 200,000 204,019
2009 20,000 18,362 1,638 2,381 150,000 152,381
2010 15,000 13,714 1,286 1,095 100,000 101,095
2011 10,000 9,099 901 194* 50,000 50,194
2012 5000 4,517 483* - - -
* Rounding up difference
9. Premium amortization table using bond outstanding method
Bonds Fraction of Premium
Year outstanding total of bonds amortization (Br. Interest Payment Interest
balance outstanding 19,780 x fraction) expense

2003 Br. 500,000 50 /275 Br. 3,596 Br. 50,000 Br. 46,404
2004 450,000 45 /275 3.237 45,000 41,763
2005 400.000 40 /275 2,878 40,000 37,122
2006 350,000 35 /275 2.517 35,000 32,483
2007 300,000 30 /275 2,158 30,000 27,842
2008 250,000 25 /275 1,798 25,000 23,202
2009 200,000 20 /275 1,439 20,000 18,561
2010 150,000 15 /275 1,079 15,000 13,921
2011 100,000 10 /275 719 10,000 9,281
2012 50,000 5 /275 360 5,000 4,640
Br. 2,750,000 2750 /2.750 Br. 19,780 Br. 275,000 Br. 255,220

10. Discount amortization table using the interest method (case 2)

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Year Interest Interest Discount Bond Principal Carrying
(A) Payment(B) expense amortization( discount Balance amount(G)=
(11%)(C) D)= (B)-(C) Balance(E) (F) (F)- (E)

Issue - - - Br. 18,620 500,000 Br. 481,380

2003 Br. 50,000 Br. 52,952 Br. 2,952 15,668 450,000 434,332
2004 45,000 47,777 2,777 12,891 400,000 387,109
2005 40,000 42,582 2,582 10,309 350,000 339,691
2006 35,000 37,366 2,366 7,943 300,000 292,057
2007 30,000 32,126 2,126 5,817 250,000 244,183
2008 25,000 26,860 1,860 3,957 200,000 196,043
2009 20,000 21,565 1,565 2,392 150,000 147,608
2010 15,000 16,237 1,237 1,155 100,000 98,845
2011 10,000 10,873 873 282* 50,000 49,718
2012 5,000 5,469 496* - - -
* Rounding up difference
11. Discount amortization table using the bonds outstanding method (case 2)
Bonds outstanding Fraction of Amortization of Interest Interest
Year total of Discount (Br. 18.620 Payment expense
bonds x faction)
outstanding
2003 Br. 500,000 50 /275 Br. 3,385 Br. 50,000 Br. 53,385
2004 450,000 45 /275 3.047 45,000 48,047
2005 400.000 40 /275 2,708 40,000 42,708
2006 350,000 35 /275 2,370 35,000 37,370
2007 300,000 30 /275 2,031 30,000 32,031
2008 250,000 25 /275 1,693 25,000 26,693
2009 200,000 20 /275 1,354 20,000 21,354
2010 150,000 15 /275 1,016 15,000 16,016
2011 100,000 10 /275 677 10,000 10,677
2012 50,000 5 /275 339 5,000 5,339
Br. 2,750,000 2750 /2.750 Br. 18,620 Br. 275,000 Br. 293,620
12. Journal entry for the amortization of the bond issue costs for 2003
Bond issue expense (Br. 25,000  10) 2,500
Unamortized bond issue costs 2,500
st
13. Journal entry to record the retirement of the 1 serial bond and the payment of the first
interest (2003)
Case 1, interest method
Bonds payable 50,000
Premium on bonds payable 3,220
Bond interest expense 46,780
Cash 100,000

Case 1, Bonds outstanding method

Bonds payable 50,000
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 Premium on bonds payable 3,596
Bond interest expense 46,404
Cash 100,000
Case 2, Interest method
Bonds payable 50,000
Bonds interest expense 52,952
Discount on bonds payable 2,952
Cash 100,000
Case 2, Bonds outstanding method
Bonds payable 50,000
Bonds interest expense 53,385
Discount on Bonds payable 3,385
Cash 100,000

Reading assignment: Straight- Line Method of Amortization of serial and term bonds
2.5 Long-Term Notes Payable
Accounting treatment for long term notes payable 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 Issued at Face Value
Illustration: Coldwell, Inc. issued a $100,000, 4-year, 10% note at face value to Flint Hills
Bank on January 1, 2011, 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)
Zero-Interest-Bearing Notes
Issuing company records the difference between the face amount and the present value (cash
received) as
 a discount and
 amortizes that amount to interest expense over the life of the note.
Illustration: Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown
Company on January 1, 2011, and received cash of $47,663. The implicit interest rate is 12%.
Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of
interest.

(a) Cash 47,663

Notes payable 47,663
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(b) Interest expense 5,720
Notes payable 5,720
($47,663 x 12%)
Interest-Bearing Notes
Illustration: McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company
on Jan. 1, 2011, and received a computer that normally sells for $31,495. The note requires
annual interest payments each Dec. 31. The market rate of interest is 12%. Prepare McCormick’s
journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 interest.

(a) Cash 31,495

Notes payable 31,495
(b) Interest expense 3,779
Cash 2,000
Notes payable 1,779
Special Notes Payable Situations
Notes Issued for Property, Goods, or Services
When exchanging the debt instrument for property, goods, or services in a bargained transaction,
the stated interest rate is presumed to be fair unless:
(1) No interest rate is stated, or
(2) The stated interest rate is unreasonable, or
(3) The face amount is materially different from the current cash price for the same or similar
items or from the current fair value of the debt instrument.
Choice of Interest Rates
If a company cannot determine the fair value of the property, goods, services, or other rights,
and if the note has no ready market, the company must approximate an applicable interest rate.
Choice of rate is affected by:
► Prevailing rates for similar instruments.
► Factors such as restrictive covenants, collateral, payment schedule and the
existing prime interest rate.
Illustration: On December 31, 2011, Wunderlich Company issued a promissory note to Brown
Interiors Company for architectural services. The note has a face value of $550,000, a due date
of December 31, 2016, and bears a stated interest rate of 2 percent, payable at the end of each
year. Wunderlich cannot readily determine the fair value of the architectural services, nor is the
note readily marketable. On the basis of Wunderlich’s credit rating, the absence of collateral, the
prime interest rate at that date, and the prevailing interest on Wunderlich’s other outstanding
debt, the company imputes an 8 percent interest rate as appropriate in this circumstance.

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Wunderlich records issuance of the note on Dec. 31, 2011, in payment for the architectural
services as follows.
Building (or Construction in Process) 418,239
Notes Payable 418,239
Wunderlich records Payment of first year’s interest and amortization of the discount as follows:
Interest expense 33,459
Notes Payable 22,459
Cash 11,000
Mortgage Notes Payable
A promissory note secured by a document called a mortgage that pledges title to property as
security for the loan.
 Most common form of long-term notes payable.
 Payable in full at maturity or in installments.
 Fixed-rate mortgage.
 Variable-rate mortgages.
2.6 Extinguishment of Non-Current Liabilities
Extinguishment with Cash before Maturity
 Reacquisition price > Net carrying amount = Loss
 Net carrying amount > Reacquisition price = Gain
 At time of reacquisition, unamortized premium or discount must be amortized up
to the reacquisition date.

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Extinguishment of Debt
Illustration: Evermaster bonds issued at a discount on January 1, 2011. 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, 2013, Evermaster calls the entire issue at 101 and
cancels it.

Evermaster records the reacquisition and cancellation of the bonds

Bonds payable 92,925
Loss on extinguishment of bonds 6,075
Cash 101,000
Extinguishment by Exchanging Assets or Securities
 Creditor should account for the non-cash assets or equity interest received at their fair value.
 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.
Illustration: 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 Disposition of Real Estate 5,000,000
Real Estate 21,000,000
Gain on Extinguishment of Debt 4,000,000
Extinguishment with Modification of Terms
Creditor may offer one or a combination of the following modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.
Illustration: On December 31, 2010, Morgan National Bank enters into a debt modification
agreement with Resorts Development Company, which is experiencing financial difficulties. The
bank restructures a $10,500,000 loan receivable issued at par (interest paid to date) by:
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 ► Reducing the principal obligation from $10,500,000 to $9,000,000;
► Extending the maturity date from December 31, 2010, to December 31, 2014; 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.
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.

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, as computed in Illustration above
($7,201,336). 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
Amortization schedule for the new note.

Fair Value Option

Companies have the option to record fair value in their accounts for most financial assets and
liabilities, including bonds and notes payable.
The IASB believes that fair value measurement for financial instruments, including financial
liabilities, provides more relevant and understandable information than amortized cost.
Fair Value Measurement
Non-current liabilities are recorded at fair value, with unrealized holding gains or losses
reported as part of net income.
Illustrations: Edmonds Company has issued €500,000 of 6 percent bonds at face value on May
1, 2010. Edmonds chooses the fair value option for these bonds. At December 31, 2010, the
value of the bonds is now €480,000 because interest rates in the market have increased to 8
percent.
Bonds Payable 20,000
Unrealized Holding Gain or Loss—Income 20,000

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Off-Balance-Sheet Financing
Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording
the obligations.
Different Forms:
Off-balance-sheet financing can take many different forms:
a. Non-consolidated subsidiary. A parent company does not have to consolidate a subsidiary
company that is less than 50 percent owned. In such cases, the parent therefore does not
report the assets and liabilities of the subsidiary. All the parent reports on its balance sheet
are the investment in the subsidiary. As a result, users of the financial statements may not
understand that the subsidiary has considerable debt for which the parent may ultimately be
liable if the subsidiary runs into financial difficulty.
b. Special-purpose entity (SPE). A company creates a special-purpose entity (SPE) to perform
a special project. To illustrate, assume that Clarke Company decides to build a new factory.
However, management does not want to report the plant or the borrowing used to fund the
construction on its balance sheet. It therefore creates an SPE, the purpose of which is to
build the plant. (This arrangement is called a project financing arrangement.) The SPE
finances and builds the plant. In return, Clarke guarantees that it or some outside party will
purchase all the products produced by the plant. (Some refer to this as a take-or-pay
contract.) As a result, Clarke might not report the asset or liability on its books. The
accounting rules in this area are complex.
c. Operating leases. Another way that companies keep debt off the balance sheet is by leasing.
Instead of owning the assets, companies lease them. Again, by meeting certain conditions,
the company has to report only rent expense each period and to provide note disclosure of
the transaction. Note that SPEs often use leases to accomplish off-balance sheet treatment.

Rationale
Why do companies engage in off-balance-sheet financing? A major reason is that many believe
that removing debt enhances the quality of the balance sheet and permits credit to be obtained
more readily and at less cost.

Second, loan covenants often limit the amount of debt a company may have. As a result, the
company uses off-balance-sheet financing because these types of commitments might not be
considered in computing the debt limitation.

Third, some argue that the asset side of the balance sheet is severely understated. For example,
companies that use LIFO costing for inventories and depreciate assets on an accelerated basis
will often have carrying amounts for inventories and property, plant, and equipment that are
much lower than their fair values. As an offset to these lower values, some believe that part of
the debt does not have to be reported. In other words, if companies report assets at fair values,
less pressure would undoubtedly exist for off-balance-sheet financing arrangements.

Whether the arguments above have merit is debatable. The general idea of “out of sight, out of
mind” may not be true in accounting. Many users of financial statements indicate that they factor
these off-balance-sheet financing arrangements into their computations when assessing debt-to-
equity relationships. Similarly, many loan covenants also attempt to account for these complex

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arrangements. Nevertheless, many companies still believe that benefits will accrue if they omit
certain obligations from the balance sheet.

Presentation and Analysis

Presentation of Non-Current Liabilities
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.
Fair value of the debt should be discloses.
Must disclose future payments for sinking fund requirements and maturity amounts of long-
term debt during each of the next five years.
Analysis of Non-Current Liabilities
Two ratios that provide information about debt-paying ability and long-run solvency are:
Total debt
1. Debt ¿total asset ratio=
Total asset
The higher the percentage of debt to total assets, the greater the risk that the company may be
unable to meet its maturing obligations.
Income before oincome taxes∧interest expense
2.×interest earned=
Interest exepense
Indicates the company’s ability to meet interest payments as they come due.
Illustration: Novartis has total liabilities of $27,862 million, total assets of $78,299 million,
interest expense of $290 million, income taxes of $1,336 million, and net income of $8,233
million. We compute Novartis’s debt to total assets and times interest earned ratios as shown

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