Chapter Two: Non-current Liabilities
Nature and Classifications of Long-term debt
Long-term debt consist 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.
Classifications of Long-
term debts are : ► Pension liabilities
► Bonds payable ► Lease liabilities
► Long-term notes payable
► Mortgages payable
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Issuing Bonds
A bond is a fixed income instrument that represents a loan
made by an investor to a borrower. It could be an agreement
b/n the lender & borrower that includes the details of the loan
and its payments:
Bond contract known as a bond indenture.
Represents a promise to pay:
1. sum of money at designated maturity date, plus
2. periodic interest at a specified rate on the maturity
amount (face value).
Paper certificate, that has a face value.
Interest payments usually made semiannually.
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Types of bond:
1. Secured and Unsecured bonds: Secured bonds are backed by a pledge of
some sort of collateral. Collateral trust bonds are secured by stocks and bonds
of other corporations. Bonds not backed by collateral are unsecured, such as
debenture and junk bonds.
2. Term, Serial bonds, and Callable bonds: Bond issues that mature on a single
date are called term bonds; bond that mature in installments are called serial
bonds. Callable bonds give the issuer the right to call and retire the bonds prior
to maturity.
3. Convertible, Commodity-backed, and Deep-discount bonds: Convertible
bond is a bond that will convert into other securities of the corporation for a
specified time after issuance. Commodity-backed bonds (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.
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Cont....ed
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 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.
Revenue bonds are a type of municipal bond that is issued by government entities, such as cities or states, to finance
revenue-generating projects. These bonds are backed by the revenue generated by the project, rather than the full faith and credit of the
issuer.
Revenue bonds are often used to finance projects such as toll roads, airports, water treatment plants, and other infrastructure projects
that generate revenue. The revenue generated by the project is used to pay the interest and principal on the bonds.
14-4
Valuation of Bonds Payable
Issuance and marketing of bonds to the public:
Usually takes weeks or months.
Issuing company must
► Arrange for underwriters such as investment
banks.
► Obtain SEC (Securities and Exchange
Commission) approval of the bond issue,
undergo audits, and issue a prospectus.
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► Have bond certificates printed.
Cont.....ed
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.
14-6
Cont......ed
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 appropriate with the issuer’s risk.
► Rate of interest actually earned by the bondholders.
14-7
Cont.....ed
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)
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)
14-8
Cont....ed
Assume Stated Rate of 8%
Market Interest Bonds Sold At
6% Premium
8% Par Value
10% Discount
14-9
Cont......ed
Illustration: Service Master Company 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.
14-10
Cont....ed
Present value of the principal:
$100,000*.59345(1/(1+0.11)^5) = $59,345.00
Present value of ordinary annuity of the
interest payments:
$9,000*3.69590(1-(1+r/m)^-n*m/r/m) =
33,263.10
Present value (selling price) of the
bond=$92,608.10 : In the above formula r
indicates that the market rate, m is number
of interest payment and n is number of
periods for the terms of the bond.
14-11
Cont....ed
Journal entry on date of isssue,Jan.1,2011
Cash--------------------92,608
Discount on bonds payable---7,392
Bonds payable--------------100,000
Journal entry to record accrued interest at
Dec.31,2011
Bond interest expense-----10,187
Bond interest payable-----9,000
Bond payable------------1,187
Journal entry to record first payment on
Jan.1,2012
Bond interest payable------9,000
Cash----------------------9,000
14-12
Cont....ed
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).
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Cont...ed
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.
14-14
Bonds Issued at Discount on Interest Date
Illustration: If Banchu Company issues Br.800,000 of
bonds on January 1, 2014, at 97%, and bearing interest at
an annual rate of 10% payable semiannually on January 1
and July 1 and the bond has a market rate of 10.62 %
and the bond is matured by 10 years, it records the
issuance as follows.
Cash (Br.800,000 x .97) 776,000
Discount on Bonds Payable 24,000
Bonds Payable 800,000
Note: Assuming the use of the straight-line method,
Br.1,200 of the discount is amortized to interest expense each
period for 20 periods (Br.24,000 ÷ 20).
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Cont.....ed
Illustration: Banchu records the first semiannual interest
payment and the bond discount on July 1, 2014, as follows.
Interest Expense 41,200
Discount on Bonds Payable 1,200
Cash 40,000
At Dec. 31, 2014, Banchu makes the following adjusting entry.
Interest Expense 41,200
Discount on Bonds Payable 1,200
Interest Payable 40,000
14-16
Bonds Issued at Premium on Interest Date
Illustration: If Banchu Company issues Br.800,000 of
bonds on January 1, 2014, at 103%, and bearing interest
at an annual rate of 10% payable semiannually on
January 1 and July 1 and the bond has a market rate of
9.41 % and the bond is matured by 10 years, it records
the issuance as follows.
Cash (Br.800,000 x .103) 824,000
Premium on Bonds Payable 24,000
Bonds Payable 800,000
Note: With the bond premium of Br.24,000, Banchu
amortizes Br.1,200 to interest expense each period for 20
14-17 periods (Br.24,000 ÷ 20).
Cont...ed
Illustration: Banchu records the first semiannual interest payment
and the bond premium on July 1, 2014, as follows.
Interest Expense 38,800
Premium on Bonds Payable 1,200
Cash 40,000
At Dec. 31, 2014, Banchu makes the following adjusting entry.
Interest Expense 38,800
Premium on Bonds Payable 1,200
Interest Payable 40,000
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Valuation of Bonds
Bonds Issued between Interest Dates
When companies issue bonds on other than the interest
payment dates,
Buyers will pay the sellers the interest accrued from the
last interest payment date to the date of issue.
On the next semiannual interest payment date,
purchasers will receive the full six months’ interest
payment.
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Bonds Issued between Interest Dates
Illustration: On March 1, 2014, Banana Corporation issues 10-year
bonds, dated January 1, 2014, with a par value of Br.800,000. These
bonds have an annual interest rate of 6 percent, payable
semiannually on January 1 and July 1. Banana records the bond
issuance at par plus accrued interest as follows.
Cash 808,000
Bonds Payable 800,000
Interest Expense (Br.800,000 x .06 x 2/12) 8,000
On July 1, 2014, four months after the date of purchase,
Banana pays the purchaser six months’ interest and makes
the following entry.
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Valuation of Bonds Payable
Effective-Interest Method
IFRS requires the use of the effective interest method. GAAP
permits the use of the straight-line method if not materially different
than the effective interest method. Produces a periodic interest
expense equal to a constant percentage of the carrying value of
the bonds.
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Effective-Interest Method
Bonds Issued at a Discount
Illustration: Evermaster Corporation issued $100,000 of 8% term
bonds on January 1, 2014, due on January 1, 2019, with interest
payable each July 1 and January 1. Investors require an effective-
interest rate of 10%. Calculate the bond proceeds.
Maturity value of bonds payable =$100,000
Present value of $100,000 due in 5 years at 10%, interest payable
semiannually = $100,000* 0.61391 = $61,391
Present value of $4,000 interest payable semiannually for 5 years at
10% annuity =$4,000* PVOA at 5% for 5 years (7.721730) = $30,887
Proceeds from sale of bonds =$ 92,278
Discount on bonds payable =$ 7,722
14-22
Effective-Interest Method
14-23
Effective-Interest Method
Journal entry on date of issue, Jan. 1, 2014.
Cash 92,278
Discount on Bonds Payable(100,000-92,278) 7,722
Bonds Payable 100,000
14-24
Effective-Interest Method
Journal entry to record first payment and amortization of the discount
on July 1, 2014.
Interest Expense 4,614
Discount on Bonds Payable 614
Cash 4,000
14-25
Effective-Interest Method
Journal entry to record accrued interest and amortization of
the discount on Dec. 31, 2014.
Interest Expense 4,645
Interest Payable 4,000
Discount on Bonds Payable 645
14-26
Effective-Interest Method
Bonds Issued at a Premium
Illustration: Evermaster Corporation issued Br.100,000 of
8% term bonds on January 1, 2014, due on January 1,
2019, 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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Effective-Interest Method
14-28
Effective-Interest Method
Journal entry on date of issue, Jan. 1, 2014.
Cash 108,530
Premium on Bonds Payable 8,530
Bonds Payable 100,000
14-29
Effective-Interest Method
Journal entry to record first payment and amortization of the
premium on July 1, 2014.
Interest Expense 3,256
Premium on Bonds Payable 744
Cash 4,000
14-30
Effective-Interest Method
Accrued Interest
What happens if Evermaster prepares financial statements
at the end of February 2014? In this case, the company
prorates the premium by the appropriate number of
months to arrive at the proper interest expense, as follows.
14-31
Effective-Interest Method
Accrued Interest
Evermaster records this accrual as follows.
Interest Expense 1,085.33
Premium on Bonds Payable 248.00
Interest Payable 1,333.33
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Effective-Interest Method
Classification of Discount and Premium
Companies report bond discounts and
bond premiums as a direct deduction
from or addition to the face amount of
the bond.
14-33
Cost of Issuing Bonds
IFRS requires that issue costs reduce the carrying
amount of the bond, which increases the effective-
interest rate. Unamortized bond issue costs are
treated as a deferred charge and amortized over the
life of the debt.
14-34
Cost of Issuing Bonds
Jan. 1,
2014
Cash 20,550,000
Unamortized Bond Issue Costs 245,000
Premium on Bonds Payable 795,000
Dec. 1, Bonds Payable 20,000,000
2014
Bond Issue Expense 24,500
Unamortized Bond Issue Costs 24,500
14-35
Extinguishment Of Debt
The term extinguishment of debt refers to the
process of removing the liability from the balance
sheet of a company.
Normally, this occurs as bonds reach their maturity
date and holders are paid the face value of the
security.
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Extinguishment of Debt (cont’d)
Illustration: On January 1, 2007, General Bell Corp. issued at 97%
bonds with a par value of Br.800,000, due in 20 years. It incurred bond
issue costs totaling Br.16,000. Eight years after the issue date,
General Bell calls the entire issue at 101% and cancels it. General Bell
computes the loss on redemption (extinguishment).
Reacquisition price ($800,000 *101)---------$808,000
Net carrying amount of bonds redeemed:
Face value----------------------------------------$800,000
Unamortized discount ($24,000*12/20)-------(14,400)
Unamortized issue costs ($16,000*12/20)-----(9,600)
both amortized using straight-line basis (776,000)
Loss on redemption $32,000
Or you can determine loss on redemption by using (101%-97%)*
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$800,000= $32,000
Extinguishment of Debt (cont’d)
General Bell records the reacquisition and cancellation of the
bonds as follows:
Bonds Payable 800,000
Loss on Redemption of Bonds 32,000
Discount on Bonds Payable 14,400
Unamortized Bond Issue Costs 9,600
Cash 808,000
End of chapter two
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