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ACG3141 > Ch 14 Long-term Liabilities > Flashcards

Ch 14 Long-term Liabilities Flashcards

1
Q

LO1 Describe the formal procedures associated with issuing long term debt.

A

Incurring long-term debt is often a formal procedure. The bylaws of corporations usually require approval by the board of directors and the stockholders before corporations can issue bonds or can make other long-term debit arrangements. Generally, long-term debt has various covenants or restrictions. The covenants and other terms of the agreement between the borrower and the lender are stated in the bond indenture or note agreement.

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2
Q

LO2 Identify various types of bond issues.

A

Various types of bond issues (5):

1) secured & unsecured
2) term, serial, & callable
3) convertible, commodity-backed, & deep discount
4) registered & bearer (coupon)
5) income & revenue bonds

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3
Q

LO3 Describe the accounting valuation for bonds at date of issuance.

A

The investment community values a bond at the present value of its future cash flows, which consist of interest and principal. The rate used to compute the present value of these cash flows is the interest rate that provides an acceptable return on an investment commensurate with the issuer’s risk characteristics. The interest rate written in terms of the bond indenture and ordinarily appearing on the bond certificate is the stated, coupon, or nominal rate. The issuer of the bonds sets the rate and expressed it as a percentage of the face value (also called the par value, principal amount, or maturity value) of the bonds. If the rate employed by the buyers differs from the stated rate, the present value of the bonds computed by the buyers will differ from the face value of the bonds. The difference between the face value and the present value of the bonds is either a discount or premium.

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4
Q

LO4 Apply the methods of bond discount and premium amortization.

A

The discount (premium) is amortized and charged (credited) to interest expense over the life of the bonds. Amortization of a discount increases bond interest expense, and amortization of a premium decreased bond interest expense. The profession’s preferred procedure for amortization of a discount or premium is the effective-interest method.

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5
Q

Effective-Interest Method

A

Step 1: Bond interest expense is computed by multiplying the carrying value of the bonds at the beginning of the period by the effective-interest rate.
Step 2: The bond discount or premium amortization is determined by comparing the bond interest with the interested to be paid.

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6
Q

LO5 Describe the accounting for the extinguishment of debt.

A

At the time of extinguishment (reacquisition, redemption, or refunding) of long-term debt, the unamortized premiums or discount and any costs of issue applicable to the debt must be amortized up to the reacquisition date. The reacquisition price is the amount paid on extinguishment or redemption before maturity, including any call premium and expense of reacquisition. On any specified date, the net carrying amount of the debt is the amount payable at maturity, adjusted for unamortized premium or discount and issue costs. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the net carrying amount is a loss from extinguishment. Gains and losses on extinguishments are recognized currently in income.

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7
Q

LO6 Explain the accounting for long-term notes payable.

A

Accounting procedures for notes and bonds are similar. Like a bond, a note is valued at the present value of its expected future interest and principal cash flows, with any discount or premium being similarly amortized over the life of the note. Whenever the face amount of the note does not reasonably represent the present value of the consideration in the exchange, company must evaluate the entire arrangement in order to properly record the exchange and the subsequent interest.

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8
Q

LO7 Describe the accounting for the fair value option.

A

Companies have the option to record fair value in their accounts for most financial assets and liabilities, including noncurrent liabilities. Fair value measurement for financial instruments, including financial liabilities provides more relevant and understandable information than amortized costs. If companies choose the fair value option, noncurrent liabilities, such as bonds and notes payable, are recorded at fair value, with unrealized holding gains or losses reported as part of net income.

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9
Q

Unrealized Holding Gain/Loss

A

the net change in the fair value of the liability from one period to another, exclusive of interest expense recognized but not recorded.

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10
Q

LO8 Explain the reporting of off-balance-sheet financing arrangements.

A

Off-balance-sheet financing is an attempt to borrow funds in such a way to prevent recording obligations. Examples: non-consolidated subsidiaries, special purpose entities, & operating leases.

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11
Q

LO9 Indicate how to present and analyze long-term debt.

A

Companies that have large amounts and numerous issues of long-term debt frequently report only one amount in the balance sheet and support this with comments and schedules in the accompanying notes. Any assets pledged as security for the debt should be shown the assets section of the balance sheet. Long-term debt that matures within one year should be reported as a currently liability, unless redemption is to be accomplished with other than current assets. If a company plans to refinance debt, convert it into stock, or retire it from a bond retirement fund, it should continue to report it as concurrent, accompanied with a note explaining the method it will use in the debt’s liquidation. Disclosure is required of future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

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12
Q

Debt to asset ratio

A

Ratio that provides info on debt-paying ability

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13
Q

Times interest earned ratio

A

Ratio that provides info on long-run solvency.

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14
Q

Long-term debt

A
  • 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, which ever is longer.
  • one of the most controversial areas in financial reporting b/c of significant impact on cash flows
  • reporting must be substantiative and informative
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15
Q

Examples of long-term debt

A 
Bonds payable
long-term notes payable
mortgage notes payable
pension liabilities
lease liabilities
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16
Q

Convenants & restrictions

A

protect lenders and borrowers although if debt levels get too high, can still suffer losses
indenture will include:
-amounts authorized to be issues
-interest rate
-due date(s)
-call provisions
-property pledged a security
-sinking fund requirements
-working capital and dividend restrictions
-limitations concerning the assumption of additional debit

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17
Q

Bond indenture

A

a contract to issue a bond

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18
Q

Bonds

A

represents a promise to pay:

  • a sum of money at a designated mature date, plus
  • periodic interest at a specified rate on the maturity amount (face value)
  • Typically evidenced by a paper certificate & $1,000 face value
  • Make interest payments semiannually but interest rate is expressed annually
  • Main purpose is to borrow for the long term when the amount of capital needed is to large for one lender to supply
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19
Q

Issuing bonds

A

3 types:

  • firm underwriting
  • best-efforts underwriting
  • private placement
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20
Q

Firm underwriting

A

investment banks may underwrite entire issue by guaranteeing a certain sum to the company, thus taking the risk of selling the bonds for whatever price they can get

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21
Q

Best-efforts underwriting

A

investment banks may sell the bond issue for a commission on the proceeds of the sale

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22
Q

Private placement

A

the issuing company may sell the bonds directly to a large institution, financial or otherwise, without the aid of an underwriter

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23
Q

Types of bonds

A
  • secured & unsecured
  • term, serial, & callable
  • convertible, commodity-backed, & deep discount
  • registered & bearer (coupon)
  • income & revenue
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24
Q

Secured bonds

A
  • 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
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25
Q

Unsecured bonds

A
  • not backed by collateral
  • is unsecured and also very risky, therefore pays a high interest rate
  • often used to finance leveraged buy-outs
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26
Q

Term bonds

A

-bond issues that mature on a single date

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27
Q

Serial bonds

A
  • bond issues that mature in installments
  • frequently used by schools or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy
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28
Q

Callable bonds

A

-give the issuer the right to call and redeems the bonds prior to maturity

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29
Q

Convertible bonds

A

-convertible into other securities of the corporation for a specified time after issuance

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30
Q

Commodity-backed bonds

A
  • 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
  • was developed in an attempt to attract capital in a tight money market
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31
Q

Deep discount bonds

A
  • also referred to as zero interest debenture bonds

- sold at a deep discount that provides the buyer’s total interest payoff at maturity

32
Q

Registered bonds

A

bonds issued in the name of the owner and require surrender of the certificate and issuance of a new certificate to complete a sale

33
Q

Bearer bonds

A
  • also called a coupon bond

- is not issued in the name of the owner and may be transferred from one owner to another by mere delivery

34
Q

Income bonds

A

pay no interest unless the issuing company is profitable

35
Q

Revenue bonds

A
  • the interest on them is paid from specified revenue sources
  • most frequently used by airports, school districts, counties, toll-road authorities, and governmental bodies
36
Q

Bond prices

A
  • interest rates - interest rates go up, bond prices go down; interest rates decrease, bond prices go up
  • term to maturity
  • call feature - decreases the value of a bond
  • supply & demand of buyers and sellers
  • relative risk
  • market conditions
  • state of the economy
37
Q

Bond valuation

A
  • present value of its expected cash flows, which consists of interest and principal
  • the rate used to compute the present value of these cash flows is the interest rate that provides an acceptable return on an investment commensurate with the issuer’s risk characteristics
38
Q

Bond interest rate

A
  • also called stated, coupon, or nominal rate
  • set by the issuer & cannot be changed
  • often printed on the bond certificate
39
Q

Face value of bond

A
  • also called par value, principal amount, or maturity value
  • difference between the face value and the present value is called either a discount or a premium
  • determines the actual price that buyers pay for the bonds
  • the price at which the bonds sell is stated as a percentage of the face/par value
40
Q

Discount

A
  • bonds sell for less than the face value
  • effective yield exceeds stated rate
  • amortized over the the period of time that the bonds are outstanding
  • straight-line method or effective-interest method
  • amortization of a discount increases interest expense
41
Q

Premium

A
  • bonds sell for more than the face value
  • effective yield is lower than the stated rate
  • amortized over the the period of time that the bonds are outstanding
  • straight-line method or effective-interest method
  • amortization of a discount decreases interest expense
42
Q

Effective yield or market rate

A

-the rate of interest actually earned by the bondholders on the principal

43
Q

Junk bonds

A
  • bonds related below BBB
  • rated below investment grade
  • experience default rates ranging from 20-50%
  • BBB rated bonds are considered one notch above junk bonds
  • very few AAA rated bonds
44
Q

Bonds issued at par on interest date

A
  • accrues no interest
  • no premium or discount
  • simply record the cash proceeds and the face value of the bonds
  • similar to notes issued at face value
45
Q

Calling bonds

A
  • issuer may call some bonds at a stated price after a certain date
  • call feature gives the issuing corporation the opportunity to reduce its bonded indebtedness or take advantage of lower interest rates
  • must amortize any premium or discount over the bond’s life to maturity b/c early redemption is not a certainty
46
Q

Bonds issued between interest dates

A
  • when companies issue bonds on other than the interest payment dates
  • buyers of the bonds 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, purchaser will receive the full six-months’ interest payment
  • amortize discount/premium from the date of sale, not the date of the bonds
47
Q

Effective-interest method

A

-preferred procedure for amortization of a discount/premium
-produces period interest expense equal to a constant percentage of the carrying value of the bonds
-both the effective interest and straight-line methods result in the same total amount of interest expense of the term of the bonds
-when materially different between the two methods, GAAP requires use of effective-interest method
Two steps:
1) compute the bond interest expense first by multiplying the carrying value of the bonds at the beginning of the period by the effective interest rate
2) determine the bond discount/premium amortization by comparing the bond interest expense with the interest (cash) to be paid

48
Q

Carrying value

A
  • face amount minus any unamortized discount or plus any unamortized premium
  • synonymous with book value
49
Q

Classification of discount/premium

A
  • discounts are not an asset b/c there is no future economic return
  • a bond discount means the company borrowed less than the face/maturity value
  • faces an actual (effective) interest rate higher than the stated (nominal) rate
  • is a liability booked to a contra account
  • premium is also a liability b/c more was borrowed than the face value
  • booked to an adjunct account
  • companies report bond discounts and bond premiums as a direct deduction from/addition to the face amount of the bond
50
Q

Cost of issuing bonds

A
  • involve engraving and printing costs
  • legal and accounting fees
  • commissions
  • promotion costs
  • charge costs to an asset account (usually long-term), unamortized bond issue costs
  • allocate unamortized bond issue costs to expense over the life of the debt
51
Q

Notes not issued at face value

A
  • if a company issues a zero-interest-bearing note solely for cash, it measures the note’s present value by the cash received
  • the implicit interest rate is the rate that equates the cash received with the amounts to be paid in the future
  • records the discount and amortizes that amount to interest expense over the life of the note
52
Q

Present value measurement

A
  • all payables that represent commitments to pay money at a determinable future date are subject to present value measurement, except for the following:
    1) normal accounts payable due within one year
    2) security deposits, retain ages, advances, or progress payments
    3) transactions between parent and subsidiary
    4) obligations payable at some INdeterminable future date
53
Q

Extinguishment of debt

A
  • if a company holds the bonds to maturity, the company does not compute any gains/losses
  • all discounts/premiums will be amortized and the carrying amount will equal the maturity (face) value
  • at the time of reacquisition, the unamortized premium/discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date
  • gains/losses must be reported as other gains/losses
54
Q

Reacquisition price

A

the amount paid on extinguishment or redemption before maturity, including any call premium and expense of reacquisition

55
Q

Net carrying amount

A

is the amount payable at maturity, adjusted for unamortized premium/discount, and cost of issuance

56
Q

Gain from extinguishment

A

any excess of the net carrying amount over the reacquisition price

57
Q

Loss from extinguishment

A

the excess of the reacquisition price over the net carrying amount

58
Q

Refunding

A
  • the replacement of an existing issuance with a new one
  • it is often advantageous for the issuer to acquire the entire outstanding bond issue and replace it with a new bond issue bearing a lower rate of interest
  • should recognize the difference (gain/loss) between the reacquisition price and the net carrying amount of the redeemed bonds in the income of the period of redemption
59
Q

Long-term notes payable

A
  • similar in substance to bonds in that both have fixed maturity dates and carry either a stated or implicit interest rate
  • different b/c long-term notes do not trade as readily as bonds in the organized public securities markets
60
Q

Notes issued for property, goods, or services

A
  • must be entered into at arm’s length
  • the stated interest rate is presumed to be fair unless:
    1) no interest rate is stated
    2) the stated interest rate is unreasonable
    3) stated face amount of the debt instrument is materially different from the current cash sales price for the same/similar items or from the current fair value of the debt instrument
  • if there is no stated interest rate, the amount of interest is the difference between the face amount of the note and the fair value of the property
61
Q

Imputation

A
  • the process of interest-rate approximation by approximating an applicable interest rate that may differ from the stated interest rate
  • the resulting interest rate is called the imputed interest rate
  • needed when a company cannot determine the fair market value of the property, goods, services, or other rights and if the note has no ready market
62
Q

Factors affecting imputed interest rate

A
  • prevailing rates for similar instruments of issuers with similar credit ratings affect the choice of the rate
  • restrictive covenants
  • collateral
  • payment schedule
  • existing prime interest rate
63
Q

Mortgage notes payable

A
  • most common form of long-term notes payable
  • promissory note secured by title to property
  • used more frequently by individuals, proprietorships, and partnerships compared to corporations
  • corporations usually find bond issues more advantageous
  • no discount/premium involved b/c the borrower receives cash for the face amount
  • if payable at maturity, classifies the mortgage payable as a long-term liability
  • if payable in installments, classifies the current installments due as current liabilities, with the remainder as a long-term liability
64
Q

Fair value option

A
  • companies have the option to record fair value in their accounts for most financial assets and liabilities
  • provides more relevant and understandable inform compared to amortized cost
  • more relevant b/c it reflects the current cash equivalent value of financial instruments
  • unrealized holding gains/losses reported as net income
  • must continue to value long-term liabilities in all subsequent periods
65
Q

Unrealized holding gain/loss

A

is the net change in the fair value of the liability from one period to another, exclusive of interest expense recognized but not recorded

66
Q

Off-balance-sheet financing

A
  • an attempt to borrow monies in such a way to prevent recording the obligations
  • consists of 3 forms:
    1) non-consolidated subsidiary
    2) special purpose entity (SPE)
    3) operating leases
67
Q

Non-consolidated subsidiary

A
  • Under GAAP, the parent company doesn’t have to consolidate a subsidiary company that is less than 50% owned.
  • Only reports on the balance sheet it’s investment in the subsidiary.
  • Subsidiary may have considerable debt that the parent company may ultimately be liable.
68
Q

Special-purpose entity (SPE)

A
  • Created to perform a special project
  • Project financing arrangement - the SPE finances and builds the a plant. Parent company doesn’t report it on their books.
  • Take-or-Pay contract - parent company or another outside company will purchase all the products produced by the plant
  • Complex accounting rules
69
Q

Operating leases

A
  • assets are not owned

- only has to report rent expense and a disclosure note

70
Q

Off-balance-sheet financing rationale

A
  • companies believe that removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at a lesser cost
  • loan covenants limit the amount of debt a company may have; use off-balance-sheet financing b/c these types of commitments may not be considered in computing the debt limitation
  • assets may be severely understated when (example) inventory is reported using LIFO and depreciate assets on an accelerated basis, as an offset to lower values some believe debt doesn’t have to be reported
71
Q

Off-balance-sheet financing disclosure

A
  • FASB has increased disclosure requirements
    1) all contractual obligations in a tabular format
    2) contingent liabilities an commitments in either a textual or tabular format
72
Q

Presentation of long-term debt

A
  • may only report one amount, supported with comments and schedules in the accompanying notes
    1) nature of the liabilities maturity dates
    2) call provisions
    3) conversion privileges
    4) restrictions imposed by creditors
    5) assets pledged/designated as security
  • long-term debt that matures within one year should be reported as a current liability, unless using non-current assets to accomplish redemption
  • must disclose method used for liquidation includes
  • fair value of the long-term debt should be disclosed if it is practical to estimate fair value
  • companies must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next 5 years
73
Q

Long-term debt analysis

A

long-term creditors and stockholders are interested in a company’s long-run solvency:
1) its ability to pay interest as it comes due
2) repay the face value of debt at maturity
two ratios:
1) debt to assets
2) times interest earned

74
Q

Debt to assets

A

measures the percentage of total assets provided by creditors

total liabilities/total assets

75
Q

Times interest earned

A

indicates the company’s ability to meet interest payments as they come due

income before income taxes + interest expense/interest expense

ACG3141 (9 decks)

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