Chapter 14: Long Term Liabilities Flashcards
Classification of Discount and Premium
Liability valuation accounts
Discount = contra account, reduces the face value of the liability
Premium = adjunct account, addition to face value of liability
Effective-interest rate amortization amount
Interest expense - Interest paid = amortization amount
Carrying value of bonds x effective rate
less face value of bonds x stated rate
= amortization amount
Treatment of bond issue costs
Recorded as a reduction to carrying value of the bond and then amortized to expense over the life of the bond
arguably should be expensed, as not technically an asset
Recording accruing interest
If financial statements do not align with interest payment dates then you need to accrue prorated amortization but ensure not to double count
Recording discount on bond or note
Demanded interest rate > stated rate
Sales price < face value of note
amortized over life of note
face value - cash received = discount
Discount on bond/ note: contra account that decreases value of note or bond
Recording premium on bond or note
Demanded interest rate < stated rate
Sales price > face value of note
amortized over life of the note
Cash received - face value = premium
premium on bond or note: adjacent account - increases the value of note or bond
Effective-interest method
AKA present value amortization
Preferred method for amortizing a discount or premium on a bond payable
carrying value x effective interest rate = interest expense
less face amount of bond x stated rate = amortization amount
produces a periodic interest expense equal to a constant percentage of the carrying value
CONSTANT RATE OF INTEREST
straight line amortization is okay but only if not materially different from this method
Recording loss on settlement of troubled debt
charged to allowance for doubtful accounts
Troubled debt restructuring
When for economic or legal reasons related to a debtor’s financial difficulties a creditor grants a concession to the debtor it would not otherwise consider
- settlement of debt at less than carrying amount
- continuation of debt with modification of terms
Troubled debt steps
1) loan origination
2) creditor recognizes loss on impairment of loans
3) loan terms modified or settled (unfavorable to creditor)
4) bankruptcy (highest possible collection amount)
Times interest earned
Ability to meet interest payments as they come due
= (net income + interest expense + income tax expense) / Interest expense
Debt to assets ratio
Percentage of total assets provided by creditors
= total liabilities / total assets
higher % of total liabilities to assets = higher rate
Long-term liabilities on balance sheet
One line on balance sheet supported by comments and schedules in the notes
report as current if maturing in one year or operating cycle UNLESS using non-current assets for redemption
Disclose liquidation methods
Fair value option
Non current liabilities reported at fair value
+ recognize unrealized holding gain or loss
- general interest rate change: reported in net income
- creditworthiness change: reported in “other comprehensive income” - any credit risk portion of gains or losses
Reporting non-current liabilities
generally at amortized amounts (face value, less payments, adjustment for premium or discounts)
BUT have the option to record fair value as it may be more relevant
Mortgage Note payable
Promissory note secured by a document that pledges the title to a property as security for a lon
“point” = 1% of face value of the note: decreases the amount the borrower receives
may be fixed rate or variable (floating rate) which is tied to the market rate
Effective interest rate
Sales price < face value = sold at a discount = demanded interest rate > stated rate
Sale price > face value = sold at premium = demanded interest rate < stated rate
Recording Bonds issued at par (face value)
Entry at sale
Debit cash
Credit bond payable
Paying interest
Debit interest expense (or interest payable if already accrued)
Credit cash
To accrue interest
Debit Interest expense
Credit interest payable
Recording bond issued at Discount
% of par (stated value usually given
Debit Cash (amount received)
Debit Discount on Bond Payable (Face value - purchase price)
Credit Bond Payable (Face value0
Accrue interest
Debit interest expense
Credit discount on bonds payable
Credit cash
Recording Bonds issued at premium
Debit Cash (amount received)
Credit premium on bonds payable
Credit bonds payable
Interest:
Debit Interest Expense
Debit Premium on bonds payable (decreases interest expense)
Credit cash
Recording amortization discount or premium on bonds payable
Discount or premium is amortized to interest expense over the life of the bond
Discount adds to total interest expense
Premium decreases total interest expense
Discount/premium on bonds payable
Recording amortization on callable bonds
Must amortize premium/ discount over the life of the bond to maturity because early redemption is not certain
Recording bonds issued between interest dates (issued at par)
Buyers pay seller the interest accrued from last payment date to date of issue
then on next payment date purchases receives full siz month interest payment
Purchase:
Debit Cash
Credit Bonds Payable
Credit Interest Expense (or interest payable)
Recording bonds issued between interest dates at a discount or premium
Debit Cash (premium amount + interest advance)
Credit Bonds payable
Credit premium on bonds payable
Credit interest expense
then amortize from date of sale
Current liabilities
Obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets or the creation of other current liabiltiies
Debt Covenants or restrictions
Describe in financial statements or notes if necessary to provide complete understanding of financial position
- call provisions
- property pledged as security
- sinking fund requirements
- working capital / dividend restrictions
- limitations on assumption of additional debt
Bonds
Promise to pay:
- sum of money at maturity date
- periodic interest at specified rate
- usually $1,000 face value denominations
- interest payments usually semi-annually
Recording discounts/ premium on bonds
Bond sold at < face value = discount (stated interest rate < market rate/effective yield)
Bond sold at > face value = premium (stated interest rate > market rate/effective yield)
Types of bonds
- secured vs unsecured (debenture = unsecured)
- term (mature on a single date), serial (mature in installments), and callable bonds
- convertible
- commodity backed/ asset linked
- deep discount bonds (zero interest debenture)
- Registered vs bearer/ coupon bonds
- income and revenue bonds (no interest/ payments unless certain profits)
Effective Yield
AKA market rate
Rate of interest actually earned by bondholder
Bonds sold at discount: effective > stated rate
Bonds sold at premium: effective < stated rate
Valuation of a bond
The present value of expected future cash flow: interest + principle
rate used for present value factor: interest rate that provides an acceptable return on investment commensurate with issuers risks characteristics
inverse relationship between market interest rate and the price of a bond
When to measure present value of note by present value of property, goods or services
- no interest rate is stated
- stated interest rate is unreasonable
- stated amount of the debt instrument is materially different from the current cash sales price for the same or similar items or from the current fair value of debt instrument
then use fair value as present value
Imputed interest rate
To estimate present value of note where no interest rate stated and no market value may be determined
- prevailing rates of issuers with similar ratings
- covenants, collateral, payment schedule
- existing prime rate
Decided once then not changed
Imputed rate then used as market rate
Computing interest with no stated rate
Difference between face value of note and fair value of property, goods or services
Recording interest on zero-interest bearing note
Discount amortization = interest expense, no cash outflow
Finding implicit interest rate for zero-interest bearing notes
Present value = cash received
Future value = face value
PV/FV = PVF for i= ? and n= known number of periods
Valuation of long-term notes payable
Valued at present value of future interest and principle cash flow
amortize discount or premium over life of note
Refunding
Replacement of existent bond issuance with new bond issuance
Recording extinguishment of debt
Re-acquisition prices
less carrying amount of bond (face value less discount / plus premium)
= loss or gain on redemption
may recall entire outstanding bond and reissue at lower rate of issuance
Reacquisition price
amount paid on extinguishment or redemption of debt before maturity including any call premium or reacquisition expense
net carrying amount > reacquisition price = gain from extinguishment
net carrying amount < reacquisition price = loss on extinguishment
amortization must be brought up to date of extinguishment
