Chapter 14: Long Term Liabilities

Question 1

Classification of Discount and Premium

Answer 1

Liability valuation accounts

Discount = contra account, reduces the face value of the liability

Premium = adjunct account, addition to face value of liability

Question 2

Effective-interest rate amortization amount

Answer 2

Interest expense - Interest paid = amortization amount

Carrying value of bonds x effective rate
less face value of bonds x stated rate
= amortization amount

Question 3

Treatment of bond issue costs

Answer 3

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

Question 4

Recording accruing interest

Answer 4

If financial statements do not align with interest payment dates then you need to accrue prorated amortization but ensure not to double count

Question 5

Recording discount on bond or note

Answer 5

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

Question 6

Recording premium on bond or note

Answer 6

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

Question 7

Effective-interest method

Answer 7

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

Question 8

Recording loss on settlement of troubled debt

Answer 8

charged to allowance for doubtful accounts

Question 9

Troubled debt restructuring

Answer 9

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

Question 10

Troubled debt steps

Answer 10

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)

Question 11

Times interest earned

Answer 11

Ability to meet interest payments as they come due

= (net income + interest expense + income tax expense) / Interest expense

Question 12

Debt to assets ratio

Answer 12

Percentage of total assets provided by creditors

= total liabilities / total assets

higher % of total liabilities to assets = higher rate

Question 13

Long-term liabilities on balance sheet

Answer 13

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

Question 14

Fair value option

Answer 14

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

Question 15

Reporting non-current liabilities

Answer 15

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

Question 16

Mortgage Note payable

Answer 16

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

Question 17

Effective interest rate

Answer 17

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

Question 18

Recording Bonds issued at par (face value)

Answer 18

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

Question 19

Recording bond issued at Discount

Answer 19

% 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

Question 20

Recording Bonds issued at premium

Answer 20

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

Question 21

Recording amortization discount or premium on bonds payable

Answer 21

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

Question 22

Recording amortization on callable bonds

Answer 22

Must amortize premium/ discount over the life of the bond to maturity because early redemption is not certain

Question 23

Recording bonds issued between interest dates (issued at par)

Answer 23

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)

Question 24

Recording bonds issued between interest dates at a discount or premium

Answer 24

Debit Cash (premium amount + interest advance)
Credit Bonds payable
Credit premium on bonds payable
Credit interest expense

then amortize from date of sale

Question 25

Current liabilities

Answer 25

Obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets or the creation of other current liabiltiies

Question 26

Debt Covenants or restrictions

Answer 26

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

Question 27

Bonds

Answer 27

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

Question 28

Recording discounts/ premium on bonds

Answer 28

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)

Question 29

Types of bonds

Answer 29

• 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)

Question 30

Effective Yield

Answer 30

AKA market rate

Rate of interest actually earned by bondholder

Bonds sold at discount: effective > stated rate

Bonds sold at premium: effective < stated rate

Question 31

Valuation of a bond

Answer 31

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

Question 32

When to measure present value of note by present value of property, goods or services

Answer 32

• 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

Question 33

Imputed interest rate

Answer 33

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

Question 34

Computing interest with no stated rate

Answer 34

Difference between face value of note and fair value of property, goods or services

Question 35

Recording interest on zero-interest bearing note

Answer 35

Discount amortization = interest expense, no cash outflow

Question 36

Finding implicit interest rate for zero-interest bearing notes

Answer 36

Present value = cash received
Future value = face value

PV/FV = PVF for i= ? and n= known number of periods

Question 37

Valuation of long-term notes payable

Answer 37

Valued at present value of future interest and principle cash flow

amortize discount or premium over life of note

Question 38

Refunding

Answer 38

Replacement of existent bond issuance with new bond issuance

Question 39

Recording extinguishment of debt

Answer 39

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

Question 40

Reacquisition price

Answer 40

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