Ch 14: Long-Term Liabilities

Question 1

Long-Term Liability Definition

Answer 1

If it does not meet the definition of a current liability, it must be long-term

Question 2

Bond definition

Answer 2

Debt instruments of issuing corporation used by that corporation to borrow funds from the general public or institutional investors

Promise to pay sum of money at designated maturity date PLUS periodic interest at a specified rate

Usually semiannual

Used when amount of capital needed is too large for one lender to supply

Question 3

Bond Price Equation

Answer 3

PV of Principal + PV of periodic interest payments

Question 4

Par value

Answer 4

stated rate = market rate

Question 5

Premium

Answer 5

stated rate > market rate

Adds to face value
Referred as adjunct account

Question 6

Discount

Answer 6

stated rate < market rate

Reduces the face or maturity about of the liability
Referred as a contra account

Question 7

Price listing

Answer 7

The price as a % of par

Question 8

Coupon listing

Answer 8

Interest rate paid as a % of par value

Question 9

Yield listing

Answer 9

Interest rate based on price

Question 10

Effective interest rate method

Answer 10

Use the original values and compute costs and benefits based on market rates at the inception of the debt

Used by majority of firms to amortize

Question 11

Mark-to-market

Answer 11

Adjust to fair or market value at each reporting date

Fair Value Option

Question 12

Accounting for Bond Issuance

Answer 12

Bonds Payable is always created for the face value amount of the bonds listed

Any difference is recorded as premium/discount at the time bond is issued

Question 13

Income statement reaction

Answer 13

Should reflect true cost of debt (market interest rate)

Question 14

Cash Flow Statement reaction

Answer 14

Should reflect any cash movements related to this obligation (interest payment based on stated interest)

Question 15

Balance sheet reaction

Answer 15

Reflects liability that corresponds to PV of future obligations

Question 16

Amortization of Bond Discount/Premium

Answer 16

Interest cost for each period is market interest rate at issuance multiplied by carrying value

Schedule of Bond Interest Amortization:
DATE CASH PAID INTEREST AMORT CV

Question 17

Extinguishment of Debt

Answer 17

Premium or discount will be fully amortized at date bonds mature

Carrying amount will equal face value

No gain or lost due to extinguishment

Debit Bonds Payable
Credit Cash

Question 18

Interest rate fluctuations

Answer 18

If interest rates increase then the market value of debt decreases

Question 19

Change of interest rates

Answer 19

No accounting entries required

Real effect: managers may choose to react to changes in interest rates by retiring debt early

Exception: regulators are moving towards “fair value” approach for all financial assets and liabilities

Question 20

Fair value option

Answer 20

Allows firms to fair value their bond liabilities, with any gain/loss on fair value recognized through income statement

Have option to record most financial assets/liabilities through this

FASB believes this will provide more relevant info than amortized cost

In addition of LT liabilities being reported at fair value, companies report unrealized holding gains/losses as part of net income or other comprehensive icome

Question 21

Early Extinguishment of debt

Answer 21

Sometimes advantageous for a company to repurchase and retire its debt

On any specified date, the net carrying amount of the bonds is the amount payable at maturity, adjusted for unamortized premium or discount

Question 22

Open market transaction

Answer 22

If the debt trades on a listed exchange, then a corporation can simply call its broker to repurchase its own debt in the market

Question 23

Embedded call option

Answer 23

The bond indenture will specify that the issuing corporation the right to repurchase the debt at a specified price

Question 24

Reacquisition price

Answer 24

Amount paid before maturity, including any call premium and expense

Question 25

Gain/loss from early extinguishment

Answer 25

If the reacquisition price is below net carrying amount of the bond, then there is a gain from extinguishment
Vice versa

These gains/losses are recognized as “non-operating gain or loss on redemption” in the Income Statement

Question 26

Bonds vs Notes

Answer 26

Both cases, company accepts cash from another entity and is expected to pay back that cash plus interest over a fixed maturity

Notes don’t trade as readily as bonds

Notes tend to be used for shorter maturities

Bonds are securities and covered by relevant securities laws, while some notes are not classified as securities and exempt

Note is valued at PV of its future interest and principal CF
Amortized over the life of the note

Difference is how its recored “Bonds vs. Notes payable”