LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. 1 Describe the formal procedures associated with issuing long-term debt.

2. 2 Identify various types of bond issues.

3. 3 Describe the accounting valuation for bonds at date of issuance.

4. 4 Apply the methods of bond discount and premium amortization.

5. 5 Explain the accounting for long-term notes payable.

6. 6 Describe the accounting for the extinguishment of non-current liabilities.

7. 7 Describe the accounting for the fair value option.

8. 8 Explain the reporting of off-balance-sheet financing arrangements.

9. 9 Indicate how to present and analyze non-current liabilities.

Going Long

The clock is ticking. Every second, it seems, someone in the world takes on more
debt. The idea of a debt clock for an individual nation is familiar to anyone who has
been to Times Square in New York, where the American public shortfall is revealed.
The world debt clock shown below (accessed in January 2014
at www.nationaldebtclocks.org) indicates the global figure for almost all government
debts in dollar terms.

Does it matter? After all, world governments owe the money to their own citizens,
not to the Martians. But the rising total is important for two reasons. First, when
government debt rises faster than economic output (as it has been doing in recent
years), this implies more state interference in the economy and higher taxes in the
future. Second, debt must be rolled over at regular intervals. This creates a
recurring popularity test for individual governments, much like reality-TV
contestants facing a public phone vote every week. Fail that vote, as various euro-
zone governments have done, and the country (and its neighbors) can be plunged
into crisis.
In addition to government debt, companies are issuing corporate debt at a record
pace. Why this trend? For one thing, low interest rates and rising inflows into fixed-
income funds have triggered record bond issuances as banks cut back lending. In
addition, for some high-rated companies, it can be riskier to borrow from a bank
than the bond markets. The reason: High-rated companies tend to rely on short-
term commercial paper, backed up by undrawn loans, to fund working capital but
are left stranded when these markets freeze up. Some are now financing
themselves with longer-term bonds instead. In fact, non-financial companies are
issuing 30-year bonds at a record pace as they look to increase long-term
borrowings, lock in low interest rates, and take advantage of investor demand. The
charts on the next page show the substantial increase in bond issues as interest
rates have fallen.

Companies, like Phillip Morris (USA), Sinopec (CHN), and Apple (USA), have all
sold 30-year bonds recently. Increases in the issuance of these bonds suggest
confidence in the economy as investors appear comfortable holding such long-term
investments. In addition, companies have a strong appetite for issuing these bonds
because they provide a substantial cash infusion at a relatively low interest rate.
Hopefully, it will work out for both the investor and the company in the long run.
Sources: A. Sakoui and N. Bullock, Companies Choose Bonds for Cheap
Funds, Financial Times (October 12,
2009); http://www.economist.com/content/global_debt_clock; V. Monga, Companies
Feast on Cheap Money Market for 30-Year Bonds, Priced at Stark Lows, Brings Out
GE, UPS and Other Once-Shy Issuers, Wall Street Journal (October 8, 2012); and
Josh Noble, Sinopec Raises 550m from Euro Bond Sale, Financial Times (October
10, 2013).

PREVIEW OF CHAPTER 14

As our opening story indicates, companies may rely on different forms of long-term
borrowing, depending on market conditions and the features of various non-current
liabilities. In this chapter, we explain the accounting issues related to non-current
liabilities. The content and organization of the chapter are as follows.

BONDS PAYABLE

LEARNING OBJECTIVE

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

Non-current liabilities (sometimes referred to as long-term debt) consist of an

expected outflow of resources arising from present obligations that are not payable
within a year or the operating cycle of the company, whichever is longer. Bonds
payable, long-term notes payable, mortgages payable, pension liabilities, and lease
liabilities are examples of non-current liabilities.

A corporation, per its bylaws, usually requires approval by the board of directors and
the shareholders before bonds or notes can be issued. The same holds true for
other types of long-term debt arrangements.

Generally, long-term debt has various covenants or restrictions that protect both
lenders and borrowers. The indenture or agreement often includes the amounts
authorized to be issued, interest rate, due date(s), call provisions, property pledged
as security, sinking fund requirements, working capital and dividend restrictions,
and limitations concerning the assumption of additional debt. Companies should
describe these features in the body of the financial statements or the notes if
important for a complete understanding of the financial position and the results of
operations.

Although it would seem that these covenants provide adequate protection to the
long-term debtholder, many bondholders suffer considerable losses when
companies add more debt to the capital structure. Consider what can happen to
bondholders in leveraged buyouts (LBOs), which are usually led by management. In
an LBO of RJR Nabisco (USA), for example, solidly rated 9 percent bonds due in
2016 plunged 20 percent in value when management announced the leveraged
buyout. Such a loss in value occurs because the additional debt added to the capital
structure increases the likelihood of default. Although covenants protect
bondholders, they can still suffer losses when debt levels get too high.

ISSUING BONDS

A bond arises from a contract known as a bond indenture. A bond represents a

promise to pay (1) a sum of money at a designated maturity date, plus (2) periodic
interest at a specified rate on the maturity amount (face value). Individual bonds
are evidenced by a paper certificate and typically have a 1,000 face value.
Companies usually make bond interest payments semiannually although the
interest rate is generally expressed as an annual rate. As discussed in the opening
story, the main purpose of bonds is to borrow for the long term when the amount of
capital needed is too large for one lender to supply. By issuing bonds in 100,
1,000, or 10,000 denominations, a company can divide a large amount of long-
term indebtedness into many small investing units, thus enabling more than one
lender to participate in the loan.

A company may sell an entire bond issue to an investment bank, which acts as a
selling agent in the process of marketing the bonds. In such arrangements,
investment banks may either underwrite the entire issue by guaranteeing a certain
sum to the company, thus taking the risk of selling the bonds for whatever price
they can get (firm underwriting). Or, they may sell the bond issue for a commission
on the proceeds of the sale (best-efforts underwriting). Alternatively, the issuing
company may sell the bonds directly to a large institution, financial or otherwise,
without the aid of an underwriter (private placement).

TYPES AND RATINGS OF BONDS

LEARNING OBJECTIVE

Identify various types of bond issues.

Presented on the next page, we define some of the more common types of bonds
found in practice.

TYPES OF BONDS
SECURED AND UNSECURED BONDS. Secured bonds are 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 shares and bonds of other corporations. Bonds
not backed by collateral are unsecured. A debenture bond is unsecured. A junk
bond is unsecured and also very risky, and therefore pays a high interest rate.
Companies often use these bonds to finance leveraged buyouts.

TERM, SERIAL BONDS, AND CALLABLE BONDS. Bond issues that mature on a
single date are called term bonds; issues that mature in installments are
called serial bonds. Serially maturing bonds are frequently used by school or
sanitary districts, municipalities, or other local taxing bodies that receive money
through a special levy. Callable bonds give the issuer the right to call and retire
the bonds prior to maturity.

CONVERTIBLE, COMMODITY-BACKED, AND DEEP-DISCOUNT BONDS. If bonds

are convertible into other securities of the corporation for a specified time after
issuance, they are convertible bonds.

Two types of bonds have been developed in an attempt to attract capital in a tight
money marketcommodity-backed bonds and deep-discount bonds. Commodity-
backed bonds (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. To
illustrate, Sunshine Mining (USA), a silver-mining company, sold two issues of
bonds redeemable with either $1,000 in cash or 50 ounces of silver, whichever is
greater at maturity, and that have a stated interest rate of 8 percent. The
accounting problem is one of projecting the maturity value, especially since silver
has fluctuated between $4 and $40 an ounce since issuance.

Deep-discount bonds, also referred to as zero-interest debenture bonds, are

sold at a discount that provides the buyer's total interest payoff at maturity.

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.

INCOME AND REVENUE BONDS. Income bonds pay no interest unless the
issuing company is profitable. Revenue bonds, so called because 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.

What do the numbers mean? ALL ABOUT BONDS

How do investors monitor their bond investments? One way is to review the bond
listings found in the newspaper or online. Corporate bond listings show the coupon
(interest) rate, maturity date, and last price. However, because corporate bonds are
more actively traded by large institutional investors, the listings also indicate the
current yield. Corporate bond listings would look like this below.

The companies issuing the bonds are listed in the first column, in this case, two
telecommunications companies, Vodafone Group (GBR) and Telecom Italia
S.p.A (ITA). In the second column is the interest rate paid by the bond as a
percentage of its par value, followed by its maturity date. The Vodafone bonds, for
example, pay 5 percent and mature on June 4, 2018. The Telecom Italia bonds pay
5.25 percent, a bit higher. The Vodafone bonds have a current yield of 4.05 percent,
based on the price of 106.66 per 1,000. In contrast, the Telecom Italia bonds at
100.00 yield 5.25 percent. The final column gives the bond rating. Vodafone, with a
rating of AA, is viewed as more creditworthy than Telecom Italia, which explains why
Vodafone's bonds sell at a higher price and lower yield.

Also, as indicated in the chapter, interest rates and the bond's term to maturity
have a real effect on bond prices. For example, an increase in interest rates will lead
to a decline in bond values. Similarly, a decrease in interest rates will lead to a rise
in bond values. The following data, based on three different bond funds,
demonstrate these relationships between interest rate changes and bond values.

Another factor that affects bond prices is the call feature, which decreases the value
of the bond. Investors must be rewarded for the risk that the issuer will call the
bond if interest rates decline, which would force the investor to reinvest at lower
rates.

VALUATION OF BONDS PAYABLE

LEARNING OBJECTIVE

Describe the accounting valuation for bonds at date of issuance.

The issuance and marketing of bonds to the public does not happen overnight. It
usually takes weeks or even months. First, the issuing company must arrange for
underwriters that will help market and sell the bonds. Then, it must obtain
regulatory approval of the bond issue, undergo audits, and issue a prospectus (a
document that describes the features of the bond and related financial information).
Finally, the company must generally have the bond certificates printed. Frequently,
the issuing company establishes the terms of a bond indenture well in advance of
the sale of the bonds. Between the time the company sets these terms and the time
it issues the bonds, the market conditions and the financial position of the issuing
corporation may change significantly. Such changes affect the marketability of the
bonds and thus their selling price.

The selling price of a bond issue is set by the supply and demand of buyers and
sellers, relative risk, market conditions, and the state of the economy. The
investment community values a bond at the present value of its expected
future cash flows, which consist of (1) interest and (2) 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 the terms of the bond indenture (and often printed on
the bond certificate) is known as the stated, coupon, or nominal rate. The issuer
of the bonds sets this rate. The stated rate is expressed as a percentage of the face
value of the bonds (also called the par value, principal amount, or maturity
value).

Bonds Issued at Par

If the rate employed by the investment community (buyers) is the same as the
stated rate, the bond sells at par. That is, the par value equals the present value of
the bonds computed by the buyers (and the current purchase price). To illustrate
the computation of the present value of a bond issue, assume that Santos
Company issues R$100,000 in bonds dated January 1, 2015, due in five years with 9
percent interest payable annually on January 1. At the time of issue, the market rate
for such bonds is 9 percent. The time diagram in Illustration 14-1 depicts both the
interest and the principal cash flows.

ILLUSTRATION 14-1
Time Diagram for Bonds Issued at Par
The actual principal and interest cash flows are discounted at a 9 percent rate for
five periods, as shown in Illustration 14-2.

ILLUSTRATION 14-2
Present Value Computation of Bond Selling at Par

By paying R$100,000 (the par value) at the date of issue, investors realize an
effective rate or yield of 9 percent over the five-year term of the bonds. Santos
makes the following entry when it issues the bonds.

Santos records accrued interest expense of R$9,000 (R$100,000 .09) at

December 31, 2015 (year-end), as follows.

It records the first interest payment as follows.

Bonds Issued at Discount or Premium

If the rate employed by the investment community (buyers) differs from the stated
rate, the present value of the bonds computed by the buyers (and the current
purchase price) will differ from the face value of the bonds. The difference between
the face value and the present value of the bonds determines the actual price that
buyers pay for the bonds. This difference is either a discount or premium. 1

If the bonds sell for less than face value, they sell at a discount.

If the bonds sell for more than face value, they sell at a premium.

The rate of interest actually earned by the bondholders is called the effective
yield. If bonds sell at a discount, the effective yield exceeds the stated
rate. Conversely, if bonds sell at a premium, the effective yield is lower than the
stated rate. Several variables affect the bond's price while it is outstanding, most
notably the market rate of interest. There is an inverse relationship between the
market interest rate and the price of the bond.

To illustrate, assume now that Santos issues R$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. The time diagram in Illustration 14-
3 depicts both the interest and the principal cash flows.

ILLUSTRATION 14-3
Time Diagram for Bonds Issued at a Discount

The actual principal and interest cash flows are discounted at an 11 percent rate for
five periods, as shown in Illustration 14-4.

ILLUSTRATION 14-4
Present Value Computation of Bond Selling at a Discount

By paying R$92,608.10 at the date of issue, investors realize an effective rate or

yield of 11 percent over the five-year term of the bonds. These bonds would sell at a
discount of R$7,391.90 (R$100,000 R$92,608.10). The price at which the bonds
sell is typically stated as a percentage of the face or par value of the bonds. For
example, the Santos bonds sold for 92.6 (92.6% of par). If Santos had received
R$102,000, then the bonds sold for 102 (102% of par).

When bonds sell at less than face value, it means that investors demand a rate of
interest higher than the stated rate. Usually, this occurs because the investors can
earn a higher rate on alternative investments of equal risk. They cannot change the
stated rate, so they refuse to pay face value for the bonds. Thus, by changing the
amount invested, they alter the effective rate of return. The investors receive
interest at the stated rate computed on the face value, but they actually earn at an
effective rate that exceeds the stated rate because they paid less than
face value for the bonds. (Later in the chapter, in Illustrations 14-8 and 14-9 on
page 661, we show an illustration for a bond that sells at a premium.)

What do the numbers mean? HOW ABOUT A 100-YEAR BOND?

Yes, some companies issue bonds with maturities that exceed a person's lifetime.
For example, lectricit de France S.A. (FRA) in early 2014 sold 100-year bonds
in Europe. The world's biggest operator of nuclear reactors priced 1.35 billion of
notes to yield 6.125 percent. The Paris-based utility is the second company to sell
century bonds in Europe, following GDF Suez S.A. (FRA) in March 2011.

Why do companies issue 100-year bonds? A number of investors, such as pension

funds and insurance companies, have non-current liabilities. They need long-
duration assets to reduce an asset-liability mismatch. While investing in a 100-year
bond carries interest-rate risk, long-term debt has an offsetting effect against long-
duration assets. Thus, this group of investors has a strong demand for these bonds.

Other multibillion-dollar companies, such as Walt Disney Company (USA) and The
Coca-Cola Company (USA), have issued 100-year bonds in the past. Many of these
bonds and debentures contain an option that lets the debt issuer partially or fully
repay the debt long before the scheduled maturity. For example, the 100-year bond
that Disney issued in 1993 is supposed to mature in 2093, but the company can
start repaying the bonds any time after 30 years (2023).

You may be surprised to learn that 1,000-year bonds also exist. A few issuers, such
as the Canadian Pacific Corporation (CAN), have issued such bonds in the past.
And, there have also been instances of bonds issued with no maturity date at all,
meaning that the debt issuers continue fulfilling the coupon payments forever.
These types of financial instruments are commonly referred to as perpetuities.

Sources: Albert Phung, Why Do Companies Issue 100-Year

Bonds? Investopedia (February 2009); and K. Linsell, EDF's Borrowing Exceeds
$12 Billion This Week with 100-Year Bond, Bloomberg (January 17, 2014).

EFFECTIVE-INTEREST METHOD

As discussed earlier, by paying more or less at issuance, investors earn a rate

different than the coupon rate on the bond. Recall that the issuing company pays
the contractual interest rate over the term of the bonds but also must pay the face
value at maturity. If the bond is issued at a discount, the amount paid at maturity is
more than the issue amount. If issued at a premium, the company pays less at
maturity relative to the issue price.

LEARNING OBJECTIVE

Apply the methods of bond discount and premium amortization.

The company records this adjustment to the cost as bond interest expense over
the life of the bonds through a process called amortization. Amortization of a
discount increases bond interest expense. Amortization of a premium
decreases bond interest expense.

The required procedure for amortization of a discount or premium is the effective-

interest method (also called present value amortization). Under the effective-
interest method, companies: [1]

See the Authoritative Literature section (page 684).

1. 1. Compute bond interest expense first by multiplying the carrying

value (book value) of the bonds at the beginning of the period by the
effective-interest rate.2

2. 2. Determine the bond discount or premium amortization next by comparing

the bond interest expense with the interest (cash) to be paid.

Illustration 14-5 depicts graphically the computation of the amortization.

ILLUSTRATION 14-5
Bond Discount and Premium Amortization Computation

The effective-interest method produces a periodic interest expense equal to a

constant percentage of the carrying value of the bonds.3

Bonds Issued at a Discount

To illustrate amortization of a discount under the effective-interest method,
Evermaster Corporation issued 100,000 of 8 percent term bonds on January 1,
2015, due on January 1, 2020, with interest payable each July 1 and January 1.
Because the investors required an effective-interest rate of 10 percent, they paid
92,278 for the 100,000 of bonds, creating a 7,722 discount. Evermaster
computes the 7,722 discount as follows. 4

ILLUSTRATION 14-6
Computation of Discount on Bonds Payable

The five-year amortization schedule appears in Illustration 14-7.

ILLUSTRATION 14-7
Bond Discount Amortization Schedule
Evermaster records the issuance of its bonds at a discount on January 1, 2015, as
follows.

It records the first interest payment on July 1, 2015, and amortization of the
discount as follows.

Evermaster records the interest expense accrued at December 31, 2015 (year-end),
and amortization of the discount as follows.

Bonds Issued at a Premium

Now assume that for the bond issue described above, investors are willing to accept
an effective-interest rate of 6 percent. In that case, they would pay 108,530 or a
premium of 8,530, computed as follows.

ILLUSTRATION 14-8
Computation of Premium on Bonds Payable
The five-year amortization schedule appears in Illustration 14-9.

ILLUSTRATION 14-9
Bond Premium Amortization Schedule
Evermaster records the issuance of its bonds at a premium on January 1, 2015, as
follows.

Evermaster records the first interest payment on July 1, 2015, and amortization of
the premium as follows.

Evermaster should amortize the discount or premium as an adjustment to interest

expense over the life of the bond in such a way as to result in a constant rate of
interest when applied to the carrying amount of debt outstanding at the beginning
of any given period.5

Accruing Interest

In our previous examples, the interest payment dates and the date the financial
statements were issued were essentially the same. For example, when Evermaster
sold bonds at a premium (page 661), the two interest payment dates coincided with
the financial reporting dates. However, what happens if Evermaster prepares
financial statements at the end of February 2015? In this case, the
company prorates the premium by the appropriate number of months to arrive at
the proper interest expense, as follows.

ILLUSTRATION 14-10
Computation of Interest Expense
Evermaster records this accrual as follows.

If the company prepares financial statements six months later, it follows the same
procedure. That is, the premium amortized would be as follows.

ILLUSTRATION 14-11
Computation of Premium Amortization

Bonds Issued Between Interest Dates

Companies usually make bond interest payments semiannually, on dates specified

in the bond indenture. When companies issue bonds on other than the interest
payment dates, bond investors will pay the issuer the interest accrued from
the last interest payment date to the date of issue. The bond investors, in
effect, pay the bond issuer in advance for that portion of the full six-months' interest
payment to which they are not entitled because they have not held the bonds for
that period. Then, on the next semiannual interest payment date, the bond
investors will receive the full six-months' interest payment.

Bonds Issued at Par. To illustrate, assume that instead of issuing its bonds on
January 1, 2015, Evermaster issued its five-year bonds, dated January 1, 2015, on
May 1, 2015, at par (100,000). Evermaster records the issuance of the bonds
between interest dates as follows.
Because Evermaster issues the bonds between interest dates, it records the bond
issuance at par (100,000) plus accrued interest (2,667). That is, the total
amount paid by the bond investor includes four months of accrued interest.

On July 1, 2015, two months after the date of purchase, Evermaster pays the
investors six months' interest, by making the following entry.

The Interest Expense account now contains a debit balance of 1,333 (4,000
2,667), which represents the proper amount of interest expensetwo months at 8
percent on 100,000.

Bonds Issued at Discount or Premium

The illustration above was simplified by having the January 1, 2015, bonds issued on
May 1, 2015, at par. However, if the bonds are issued at a discount or premium
between interest dates, Evermaster must not only account for the partial cash
interest payment but also the amount of effective amortization for the
partial period.

To illustrate, assume that the Evermaster 8-percent bonds were issued on May 1,
2015, to yield 6 percent. Thus, the bonds are issued at a premium; in this case, the
price is 108,039.6 Evermaster records the issuance of the bonds between interest
dates as follows.

In this case, Evermaster receives a total of 110,706 at issuance, comprised of the

bond price of 108,039 plus the accrued interest of 2,667. Following the effective-
interest procedures, Evermaster then determines interest expense from the date of
sale (May 1, 2015), not from the date of the bonds (January 1, 2015).

Illustration 14-12 provides the computation, using the effective-interest rate of 6

percent.

ILLUSTRATION 14-12
Partial Period Interest Amortization

The bond interest expense therefore for the two months (May and June) is 1,080.

The premium amortization of the bonds is also for only two months. It is computed
by taking the difference between the net cash paid related to bond interest and the
effective-interest expense of 1,080. Illustration 14-13 shows the computation of
the partial amortization, using the effective-interest rate of 6 percent.

ILLUSTRATION 14-13
Partial Period Interest Amortization

As indicated, both the bond interest expense and amortization reflect the shorter
two-month period between the issue date and the first interest payment.
Evermaster therefore makes the following entries on July 1, 2015, to record the
interest payment and the premium amortization.
The Interest Expense account now contains a debit balance of 1,080 (4,000
2,667 253), which represents the proper amount of interest expensetwo
months at an effective annual interest rate of 6 percent on 108,039.

What do the numbers mean? YOUR DEBT IS KILLING MY EQUITY

Traditionally, investors in the equity and bond markets operate in their own
separate worlds. However, in recent volatile markets, even quiet murmurs in the
bond market have been amplified into movements (usually negative) in share
prices. At one extreme, these gyrations heralded the demise of a company well
before the investors could sniff out the problem.

The swift decline of Enron (USA) in late 2001 provided the ultimate lesson: A
company with no credit is no company at all. As one analyst remarked, You can no
longer have an opinion on a company's shares without having an appreciation for its
credit rating. Indeed, other energy companies also felt the effect of Enron's
troubles as lenders tightened or closed down the credit supply and raised interest
rates on already-high levels of debt. The result? Share prices took a hit.

Other industries are not immune from the negative shareholder effects of credit
problems. For example, analysts at TheStreet.com compiled a list of companies
with a focus on debt levels. Companies like Copel CIA (BRA) (an energy distribution
company) were rewarded with improved share ratings, based on their manageable
debt levels. In contrast, other companies with high debt levels and low ability to
cover interest costs were not viewed very favorably. Among them is Goodyear Tire
and Rubber (USA), which reported debt six times greater than its equity. Goodyear
is a classic example of how swift and crippling a heavy debt-load can be. Not too
long ago, Goodyear had a good credit rating and was paying a good dividend. But,
with mounting operating losses, Goodyear's debt became a huge burden, its debt
rating fell to junk status, the company cut its dividend, and its share price dropped
80 percent. This was yet another example of share prices taking a hit due to
concerns about credit quality. Thus, even if your investment tastes are in equity,
keep an eye on the liabilities.

Sources: Adapted from Steven Vames, Credit Quality, Stock Investing Seem to Go
Hand in Hand, Wall Street Journal (April 1, 2002), p. R4; Herb Greenberg, The
Hidden Dangers of Debt, Fortune (July 21, 2003), p. 153; and Christine Richard,
Holders of Corporate Bonds Seek Protection from Risk, Wall Street
Journal (December 1718, 2005), p. B4.

LONG-TERM NOTES PAYABLE

LEARNING OBJECTIVE

Explain the accounting for long-term notes payable.

The difference between current notes payable and long-term notes payable is
the maturity date. As discussed in Chapter 13, short-term notes payable are those
that companies expect to pay within a year or the operating cyclewhichever is
longer. Long-term notes are similar in substance to bonds in that both have fixed
maturity dates and carry either a stated or implicit interest rate. However, notes do
not trade as readily as bonds in the organized public securities markets. Non-
corporate and small corporate enterprises issue notes as their long-term
instruments. Larger corporations issue both long-term notes and bonds.

Accounting for notes and bonds is quite similar. Like a bond, a note is valued at
the present value of its future interest and principal cash flows. The
company amortizes any discount or premium over the life of the note, just
as it would the discount or premium on a bond. Companies compute the present
value of an interest-bearing note, record its issuance, and amortize any discount
or premium and accrual of interest in the same way that they do for bonds (as
shown on pages 657664 of this chapter).

As you might expect, accounting for long-term notes payable parallels accounting
for long-term notes receivable, as was presented in Chapter 7.

NOTES ISSUED AT FACE VALUE

In Chapter 7, we discussed the recognition of a 10,000, three-year note

Scandinavian Imports issued at face value to Bigelow Corp. In this transaction, the
stated rate and the effective rate were both 10 percent. The time diagram and
present value computation on page 309 of Chapter 7 (see Illustration 7-12) for
Bigelow Corp. would be the same for the issuer of the note, Scandinavian Imports,
in recognizing a note payable. Because the present value of the note and its face
value are the same, 10,000, Scandinavian would recognize no premium or
discount. It records the issuance of the note as follows.

Scandinavian Imports would recognize the interest incurred each year as follows.
NOTES NOT ISSUED AT FACE VALUE

Zero-Interest-Bearing Notes

If a company issues a zero-interest-bearing (non-interest-bearing) note 7 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. The issuing company records the difference between the
face amount and the present value (cash received) as a discount and amortizes
that amount to interest expense over the life of the note.

An example of such a transaction is Beneficial Corporation's (USA) offering of

$150 million of zero-coupon notes (deep-discount bonds) having an eight-year life.
With a face value of $1,000 each, these notes sold for $327a deep discount of
$673 each. The present value of each note is the cash proceeds of $327. We can
calculate the interest rate by determining the rate that equates the amount the
investor currently pays with the amount to be received in the future. Thus,
Beneficial amortizes the discount over the eight-year life of the notes using an
effective-interest rate of 15 percent.8

To illustrate the entries and the amortization schedule, assume that Turtle Cove
Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah
Company illustrated on page 309 of Chapter 7 (notes receivable). The implicit rate
that equated the total cash to be paid ($10,000 at maturity) to the present value of
the future cash flows ($7,721.80 cash proceeds at date of issuance) was 9 percent.
(The present value of $1 for three periods at 9 percent is $0.77218.) Illustration 14-
14shows the time diagram for the single cash flow.
ILLUSTRATION 14-14
Time Diagram for Zero-Interest Note

Turtle Cove records issuance of the note as follows.

Turtle Cove amortizes the discount and recognizes interest expense annually using
the effective-interest method. Illustration 14-15 shows the three-year discount
amortization and interest expense schedule. (This schedule is similar to the note
receivable schedule of Jeremiah Company in Illustration 7-14.)

ILLUSTRATION 14-15
Schedule of Note Discount Amortization

Turtle Cove records interest expense at the end of the first year using the effective
interest method as follows.
The total amount of the discount, $2,278.20 in this case, represents the expense
that Turtle Cove Company will incur on the note over the three years.

Interest-Bearing Notes

The zero-interest-bearing note above is an example of the extreme difference

between the stated rate and the effective rate. In many cases, the difference
between these rates is not so great.

Consider the example from Chapter 7 where Marie Co. issued for cash a 10,000,
three-year note bearing interest at 10 percent to Morgan Corp. The market rate of
interest for a note of similar risk is 12 percent. Illustration 7-15 (page 311) shows
the time diagram depicting the cash flows and the computation of the present value
of this note. In this case, because the effective rate of interest (12%) is greater than
the stated rate (10%), the present value of the note is less than the face value. That
is, the note is exchanged at a discount. Marie Co. records the issuance of the note
as follows.

Marie Co. then amortizes the discount and recognizes interest expense annually
using the effective-interest method. Illustration 14-16 shows the three-year
discount amortization and interest expense schedule.

ILLUSTRATION 14-16
Schedule of Note Discount Amortization

Marie Co. records payment of the annual interest and amortization of the discount
for the first year as follows (amounts per amortization schedule).
When the present value exceeds the face value, Marie Co. exchanges the note at a
premium. It does so by recording the premium as a credit and amortizing it using
the effective-interest method over the life of the note as annual reductions in the
amount of interest expense recognized.

SPECIAL NOTES PAYABLE SITUATIONS

Notes Issued for Property, Goods, or Services

Sometimes, companies may receive property, goods, or services in exchange for a

note payable. When exchanging the debt instrument for property, goods, or
services in a bargained transaction entered into at arm's length, the stated interest
rate is presumed to be fair unless:

1. 1. No interest rate is stated, or

2. 2. The stated interest rate is unreasonable, or

3. 3. The stated face 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 the debt instrument.

In these circumstances, the company measures the present value of the debt
instrument by the fair value of the property, goods, or services or by an amount
that reasonably approximates the fair value of the note. [3] If there is no stated
rate of interest, the amount of interest is the difference between the face
amount of the note and the fair value of the property.

For example, assume that Scenic Development Company sells land having a cash
sale price of 200,000 to Health Spa, Inc. In exchange for the land, Health Spa gives
a five-year, 293,866, zero-interest-bearing note. The 200,000 cash sale price
represents the present value of the 293,866 note discounted at 8 percent for five
years. Should both parties record the transaction on the sale date at the face
amount of the note, which is 293,866? Noif they did, Health Spa's Land account
and Scenic's sales would be overstated by 93,866 (the interest for five years at an
effective rate of 8 percent). Similarly, interest revenue to Scenic and interest
expense to Health Spa for the five-year period would be understated by 93,866.

Because the difference between the cash sale price of 200,000 and the 293,866
face amount of the note represents interest at an effective rate of 8 percent, the
companies' transaction is recorded at the exchange date as follows.

ILLUSTRATION 14-17
Entries for Non-Cash Note Transaction
During the five-year life of the note, Health Spa amortizes annually a portion of the
discount of 93,866 as a charge to interest expense. Scenic Development records
interest revenue totaling 93,866 over the five-year period by also amortizing the
discount. The effective-interest method is required, unless the results obtained from
using another method are not materially different from those that result from the
effective-interest method.

Choice of Interest Rate

In note transactions, the effective or market interest rate is either evident or

determinable by other factors involved in the exchange, such as the fair value of
what is given or received. But, if a company cannot determine the fair value of the
property, goods, services, or other rights, and if the note has no ready market, the
problem of determining the present value of the note is more difficult. To estimate
the present value of a note under such circumstances, a company must
approximate an applicable interest rate that may differ from the stated interest
rate. This process of interest-rate approximation is called imputation, and the
resulting interest rate is called an imputed interest rate.

The prevailing rates for similar instruments of issuers with similar credit ratings
affect the choice of a rate. Other factors such as restrictive covenants, collateral,
payment schedule, and the existing prime interest rate also play a part. Companies
determine the imputed interest rate when they issue a note; any subsequent
changes in prevailing interest rates are ignored.

To illustrate, assume that on December 31, 2015, Wunderlich Company issued a

promissory note to Brown Interiors Company for architectural services. The note has
a face value of 550,000, a due date of December 31, 2020, and bears a stated
interest rate of 2 percent, payable at the end of each year. Wunderlich cannot
readily determine the fair value of the architectural services, nor is the note readily
marketable. On the basis of Wunderlich's credit rating, the absence of collateral, the
prime interest rate at that date, and the prevailing interest on Wunderlich's other
outstanding debt, the company imputes an 8 percent interest rate as appropriate in
this circumstance. Illustration 14-18 shows the time diagram depicting both cash
flows.

ILLUSTRATION 14-18
Time Diagram for Interest-Bearing Note
The present value of the note and the imputed fair value of the architectural
services are determined as follows.

ILLUSTRATION 14-19
Computation of Imputed Fair Value and Note Discount

Wunderlich records issuance of the note in payment for the architectural services as
follows.

The five-year amortization schedule appears below.

ILLUSTRATION 14-20
Schedule of Discount Amortization Using Imputed Interest Rate
Wunderlich records payment of the first year's interest and amortization of the
discount as follows.

MORTGAGE NOTES PAYABLE

A common form of long-term notes payable is a mortgage note payable.

A mortgage note payable is a promissory note secured by a document called a
mortgage that pledges title to property as security for the loan. Individuals,
proprietorships, and partnerships use mortgage notes payable more frequently than
do corporations. (Corporations usually find that bond issues offer advantages in
obtaining large loans.)

The borrower usually receives cash for the face amount of the mortgage note. In
that case, the face amount of the note is the true liability, and no discount or
premium is involved. When the lender assesses points, however, the total amount
received by the borrower is less than the face amount of the note. 9 Points raise the
effective-interest rate above the rate specified in the note. A point is 1 percent of
the face of the note.

For example, assume that Harrick Co. borrows $1,000,000, signing a 20-year
mortgage note with a stated interest rate of 10.75 percent as part of the financing
for a new plant. If Associated Savings demands 4 points to close the financing,
Harrick will receive 4 percent less than $1,000,000or $960,000but it will be
obligated to repay the entire $1,000,000 at the rate of $10,150 per month. Because
Harrick received only $960,000 and must repay $1,000,000, its effective-interest
rate is increased to approximately 11.3 percent on the money actually borrowed.

On the statement of financial position, Harrick should report the mortgage note
payable as a liability using a title such as Mortgage Notes Payable or Notes
PayableSecured, with a brief disclosure of the property pledged in notes to the
financial statements.

Mortgages may be payable in full at maturity or in installments over the life of the
loan. If payable at maturity, Harrick classifies its mortgage payable as a non-current
liability on the statement of financial position until such time as the approaching
maturity date warrants showing it as a current liability. If it is payable in
installments, Harrick shows the current installments due as current liabilities, with
the remainder as a non-current liability.

Lenders have partially replaced the traditional fixed-rate mortgage with

alternative mortgage arrangements. Most lenders offer variable-rate
mortgages (also called floating-rate or adjustable-rate mortgages) featuring
interest rates tied to changes in the fluctuating market rate. Generally, the variable-
rate lenders adjust the interest rate at either one- or three-year intervals, pegging
the adjustments to changes in the prime rate or the London Interbank Offering
(LIBOR) rate.

SPECIAL ISSUES RELATED TO NON-CURRENT LIABILITIES

Reporting of non-current liabilities is one of the most controversial areas in financial

reporting. Because non-current liabilities have a significant impact on the cash flows
of the company, reporting requirements must be substantive and informative. Four
additional reporting issues related to non-current liabilities are addressed in this
section:
 LEARNING OBJECTIVE

Describe the accounting for extinguishment of non-current liabilities.

1. 1. Extinguishment of non-current liabilities.

2. 2. Fair value option.

3. 3. Off-balance-sheet financing.

4. 4. Presentation and analysis.

EXTINGUISHMENT OF NON-CURRENT LIABILITIES

How do companies record the payment of non-current liabilitiesoften referred to

as extinguishment of debt? If a company holds the bonds (or any other form of
debt security) to maturity, the answer is straightforward: The company does not
compute any gains or losses. It will have fully amortized any premium or discount
and any issue costs at the date the bonds mature. As a result, the carrying amount,
the maturity (face) value, and the fair value of the bond are the same. Therefore, no
gain or loss exists.

In this section, we discuss extinguishment of debt under three common additional

situations:

1. 1. Extinguishment with cash before maturity,

2. 2. Extinguishment by transferring assets or securities, and

3. 3. Extinguishment with modification of terms.

Extinguishment with Cash before Maturity

In some cases, a company extinguishes debt before its maturity date. 10 The amount
paid on extinguishment or redemption before maturity, including any call premium
and expense of reacquisition, is called the reacquisition price. On any specified
date, the carrying amount of the bonds is the amount payable at maturity,
adjusted for unamortized premium or discount. Any excess of the net carrying
amount over the reacquisition price is a gain from extinguishment. The excess of
the reacquisition price over the carrying amount is a loss from extinguishment.
At the time of reacquisition, the unamortized premium or discount must be
amortized up to the reacquisition date.

To illustrate, we use the Evermaster bonds issued at a discount on January 1, 2015.

These bonds are due in five years. The bonds have a par value of 100,000, a
coupon rate of 8 percent paid semiannually, and were sold to yield 10 percent. The
amortization schedule for the Evermaster bonds is presented in Illustration 14-21.
ILLUSTRATION 14-21
Bond Premium Amortization Schedule, Bond Extinguishment

Two years after the issue date on January 1, 2017, Evermaster calls the entire issue
at 101 and cancels it.11 As indicated in the amortization schedule, the carrying value
of the bonds on January 1, 2017, is 94,925. Illustration 14-22 indicates how
Evermaster computes the loss on redemption (extinguishment).

ILLUSTRATION 14-22
Computation of Loss on Redemption of Bonds

Evermaster records the reacquisition and cancellation of the bonds as follows.

Note that 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. The
replacement of an existing issuance with a new one is called refunding. Whether
the early redemption or other extinguishment of outstanding bonds is a non-
refunding or a refunding situation, a company should recognize the difference (gain
or loss) between the reacquisition price and the carrying amount of the redeemed
bonds in income of the period of redemption.

Extinguishment by Exchanging Assets or Securities

In addition to using cash, settling a debt obligation can involve either a transfer of
non-cash assets (real estate, receivables, or other assets) or the issuance of the
debtor's shares. In these situations, the creditor should account for the non-
cash assets or equity interest received at their fair value.

The debtor must determine the excess of the carrying amount of the payable over
the fair value of the assets or equity transferred (gain). 12 The debtor recognizes a
gain equal to the amount of the excess. In addition, the debtor recognizes a gain or
loss on disposition of assets to the extent that the fair value of those assets differs
from their carrying amount (book value).

Transfer of Assets. Assume that Hamburg Bank loaned 20,000,000 to Bonn

Mortgage Company. Bonn, in turn, invested these monies in residential apartment
buildings. However, because of low occupancy rates, it cannot meet its loan
obligations. Hamburg Bank agrees to accept from Bonn Mortgage real estate with a
fair value of 16,000,000 in full settlement of the 20,000,000 loan obligation. The
real estate has a carrying value of 21,000,000 on the books of Bonn Mortgage.
Bonn (debtor) records this transaction as follows.

Bonn Mortgage has a loss on the disposition of real estate in the amount of
5,000,000 (the difference between the 21,000,000 book value and the
16,000,000 fair value). In addition, it has a gain on settlement of debt of
4,000,000 (the difference between the 20,000,000 carrying amount of the note
payable and the 16,000,000 fair value of the real estate).

Granting of Equity Interest. Now assume that Hamburg Bank agrees to accept
from Bonn Mortgage 320,000 ordinary shares (10 par) that have a fair value of
16,000,000, in full settlement of the 20,000,000 loan obligation. Bonn Mortgage
(debtor) records this transaction as follows.

It records the ordinary shares issued in the normal manner. It records the difference
between the par value and the fair value of the shares as share premium.
Extinguishment with Modification of Terms

Practically every day, the Wall Street Journal or the Financial Times runs a story
about some company in financial difficulty, such as Nakheel (ARE)
or Parmalat (ITA). In many of these situations, the creditor may grant a borrower
concessions with respect to settlement. The creditor offers these concessions to
ensure the highest possible collection on the loan. For example, a creditor may offer
one or a combination of the following modifications:

1. 1. Reduction of the stated interest rate.

2. 2. Extension of the maturity date of the face amount of the debt.

3. 3. Reduction of the face amount of the debt.

4. 4. Reduction or deferral of any accrued interest.

As with other extinguishments, when a creditor grants favorable concessions on the

terms of a loan, the debtor has an economic gain. Thus, the accounting for
modifications is similar to that for other extinguishments. That is, the original
obligation is extinguished, the new payable is recorded at fair value, and a gain is
recognized for the difference in the fair value of the new obligation and the carrying
value of the old obligation.13

To illustrate, assume that on December 31, 2015, Morgan National Bank enters into
a debt modification agreement with Resorts Development Company, which is
experiencing financial difficulties. The bank restructures a 10,500,000 loan
receivable issued at par (interest paid to date) by:

Reducing the principal obligation from 10,500,000 to 9,000,000;

Extending the maturity date from December 31, 2015, to December 31,
2019; and

Reducing the interest rate from the historical effective rate of 12 percent to 8
percent. Given Resorts Development's financial distress, its market-based
borrowing rate is 15 percent.

IFRS requires the modification to be accounted for as an extinguishment of the old

note and issuance of the new note, measured at fair value. [6] Illustration 14-
23 shows the calculation of the fair value of the modified note, using Resorts
Development's market discount rate of 15 percent.

ILLUSTRATION 14-23
Fair Value of Restructured Note
The gain on the modification is 3,298,664, which is the difference between the
prior carrying value (10,500,000) and the fair value of the restructured note, as
computed in Illustration 14-23(7,201,336). Given this information, Resorts
Development makes the following entry to record the modification.

Illustration 14-24 shows the amortization schedule for the new note, following the
modification.

ILLUSTRATION 14-24
Schedule of Interest and Amortization after Debt Modification

Resorts Development recognizes interest expense on this note using the effective
rate of 15 percent. Thus, on December 31, 2016 (date of first interest payment after
restructure), Resorts Development makes the following entry.

Resorts Development makes a similar entry (except for different amounts for credits
to Notes Payable and debits to Interest Expense) each year until maturity. At
maturity, Resorts Development makes the following entry.
In summary, following the modification, Resorts Development has extinguished the
old note with an effective rate of 12 percent and now has a new loan with a much
higher effective rate of 15 percent.

FAIR VALUE OPTION

LEARNING OBJECTIVE

Describe the accounting for the fair value option.

As indicated earlier, non-current liabilities such as bonds and notes payable are
generally measured at amortized cost (face value of the payable, adjusted for any
payments and amortization of any premium or discount). However, companies have
the option to record fair value in their accounts for most financial assets and
liabilities, including bonds and notes payable. [7] As discussed in Chapter 7(pages
314315), the IASB believes that fair value measurement for financial instruments,
including financial liabilities, provides more relevant and understandable
information than amortized cost. It considers fair value to be more relevant because
it reflects the current cash equivalent value of financial instruments.

Fair Value Measurement

If companies choose the fair value option, non-current liabilities such as bonds
and notes payable are recorded at fair value, with unrealized holding gains or losses
reported as part of net income. An unrealized holding gain or loss is the net
change in the fair value of the liability from one period to another, exclusive of
interest expense recognized but not recorded. As a result, the company reports the
liability at fair value each reporting date. In addition, it reports the change in value
as part of net income.

To illustrate, Edmonds Company has issued 500,000 of 6 percent bonds at face

value on May 1, 2015. Edmonds chooses the fair value option for these bonds. At
December 31, 2015, the value of the bonds is now 480,000 because interest rates
in the market have increased to 8 percent. The value of the debt securities falls
because the bond is paying less than market rate for similar securities. Under the
fair value option, Edmonds makes the following entry.

As the journal entry indicates, the value of the bonds declined. This decline leads to
a reduction in the bond liability and a resulting unrealized holding gain, which is
reported as part of net income. The value of Edmonds' debt declined because
interest rates increased. It should be emphasized that Edmonds must continue to
value the bonds payable at fair value in all subsequent periods.

Fair Value Controversy

With the Edmonds bonds, we assumed that the decline in value of the bonds was
due to an interest rate increase. In other situations, the decline may occur because
the bonds become more likely to default. That is, if the creditworthiness of
Edmonds Company declines, the value of its debt also declines. If its
creditworthiness declines, its bond investors are receiving a lower rate relative to
investors with similar-risk investments. If Edmonds is using the fair value option,
changes in the fair value of the bonds payable for a decline in creditworthiness are
included as part of income. Some question how Edmonds can record a gain when its
creditworthiness is becoming worse. As one writer observed, It seems
counterintuitive. However, the IASB notes that the debtholders' loss is the
shareholders' gain. That is, the shareholders' claims on the assets of the company
increase when the value of the debtholders' claims declines. In addition, the
worsening credit position may indicate that the assets of the company are declining
in value as well. Thus, the company may be reporting losses on the asset side,
which will be offsetting gains on the liability side.

The IASB apparently agrees with this statement and requires that the effects of
changes in a company's credit risk should not affect profit and loss unless the
liability is held for trading. [8] Therefore, any change in the value of the liability due
to credit risk changes should be reported in other comprehensive income. To
illustrate, assume the change in the interest rate related to the Edmonds Company
bonds described in the previous section changed from 6 percent to 8 percent due to
a decrease in the credit quality of these bonds. Under the fair value option,
Edmonds makes the following entry.

This entry recognizes the decline in the fair value of the liability and a resulting
unrealized holding gain, which is reported as part of other comprehensive income.
The value of the Edmonds bonds declined because of the change in its credit risk,
not because of general market conditions. Edmonds then continues to value the
bonds payable at fair value in all subsequent periods.
OFF-BALANCE-SHEET FINANCING

LEARNING OBJECTIVE

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

What do Air Berlin (DEU), HSBC (GBR), China Construction Bank Corp. (CHN),
and Enron (USA) have in common? They all have been accused of using off-
balance-sheet financing to minimize the reporting of debt on their statements of
financial position.14 Off-balance-sheet financing is an attempt to borrow monies
in such a way to prevent recording the obligations. It has become an issue of
extreme importance. Many allege that Enron, in one of the largest corporate failures
on record, hid a considerable amount of its debt off the statement of financial
position. As a result, any company that uses off-balance-sheet financing today risks
investors dumping their shares. Consequently (as discussed in the What Do the
Numbers Mean? box on page 664), their share price will suffer. Nevertheless, a
considerable amount of off-balance-sheet financing continues to exist. As one writer
noted, The basic drives of humans are few: to get enough food, to find shelter, and
to keep debt off the balance sheet.

Different Forms

Off-balance-sheet financing can take many different forms:

1. 1. Non-consolidated subsidiary. Under IFRS, a parent company does not

have to consolidate a subsidiary company that is less than 50 percent owned.
In such cases, the parent therefore does not report the assets and liabilities of
the subsidiary. All the parent reports on its statement of financial position is
the investment in the subsidiary. As a result, users of the financial statements
may not understand that the subsidiary has considerable debt for which the
parent may ultimately be liable if the subsidiary runs into financial difficulty.

2. 2. Special purpose entity (SPE). A company creates a special purpose

entity (SPE) to perform a special project. To illustrate, assume that Clarke
Company decides to build a new factory. However, management does not
want to report the plant or the borrowing used to fund the construction on its
statement of financial position. It therefore creates an SPE, the purpose of
which is to build the plant. (This arrangement is called a project financing
arrangement.) The SPE finances and builds the plant. In return, Clarke
guarantees that it or some outside party will purchase all the products
produced by the plant (sometimes referred to as a take-or-pay contract).
As a result, Clarke might not report the asset or liability on its books.

3. 3. Operating leases. Another way that companies keep debt off the
statement of financial position is by leasing. Instead of owning the assets,
companies lease them. Again, by meeting certain conditions, the company
 has to report only rent expense each period and to provide note disclosure of
the transaction. Note that SPEs often use leases to accomplish off-balance-
sheet treatment. We discuss accounting for lease transactions extensively
in Chapter 21.

Rationale

Why do companies engage in off-balance-sheet financing? A major reason is that

many believe that removing debt enhances the quality of the statement of
financial position and permits credit to be obtained more readily and at less cost.

Second, loan covenants often limit the amount of debt a company may have. As a
result, the company uses off-balance-sheet financing because these types of
commitments might not be considered in computing debt limits.

Third, some argue that the asset side of the statement of financial position is
severely understated. For example, companies that depreciate assets on an
accelerated basis will often have carrying amounts for property, plant, and
equipment that are much lower than their fair values. As an offset to these lower
values, some believe that part of the debt does not have to be reported. In other
words, if companies report assets at fair values, less pressure would
undoubtedly exist for off-balance-sheet financing arrangements.

Whether the arguments above have merit is debatable. The general idea of out of
sight, out of mind may not be true in accounting. Many users of financial
statements indicate that they attempt to factor these off-balance-sheet financing
arrangements into their computations when assessing debt to equity relationships.
Similarly, many loan covenants also attempt to account for these complex
arrangements. Nevertheless, many companies still believe that benefits will accrue
if they omit certain obligations from the statement of financial position.

As a response to off-balance-sheet financing arrangements, the IASB has increased

disclosure (note) requirements. This response is consistent with an efficient
markets philosophy: The important question is not whether the presentation is off-
balance-sheet or not but whether the items are disclosed at all. In addition, the U.S.
SEC now requires companies that it regulates to disclose (1) all contractual
obligations in a tabular format and (2) contingent liabilities and commitments in
either a textual or tabular format. An example of this disclosure appears in the
Evolving Issue box on page 679.15

We believe that recording more obligations on the statement of financial position

will enhance financial reporting. Given the problems with companies such as
Enron, Tiger Air (AUS), Petra Perdana (MYS), and Washington Mutual (USA)
and on-going efforts by the IASB and market regulators, we expect that less off-
balance-sheet financing will occur in the future. 16
 Evolving Issue OFF-AND-ON REPORTING

The off-balance-sheet world is slowly but surely becoming more on-balance-sheet.

New rules on guarantees and consolidation of SPEs are doing their part to increase
the amount of debt reported on corporate statements of financial position. See
footnote 15 (page 678) for a discussion of the IASB's consolidation guidance.

In addition, companies must disclose off-balance-sheet arrangements and

contractual obligations that currently have, or are reasonably likely to have, a
material future effect on the companies' financial condition. Presented below
is Novartis Group's (CHE) tabular disclosure of its contractual obligations. Because
Novartis lists its securities in the United States, it is subject to U.S. SEC rules.

Enron's (USA) abuse of off-balance-sheet financing to hide debt was shocking and
inappropriate. One silver lining in the Enron debacle, however, is that the standard-
setting bodies are now providing increased guidance on companies' reporting of
contractual obligations. We believe the new U.S. SEC rule, which requires companies
to report their obligations over a period of time, will be extremely useful to the
investment community.

PRESENTATION AND ANALYSIS

Presentation of Non-Current Liabilities

Companies that have large amounts and numerous issues of non-current liabilities
frequently report only one amount in the statement of financial position, supported
with comments and schedules in the accompanying notes. Long-term debt
that matures within one year should be reported as a current liability, unless
using non-current assets to accomplish retirement. If the company plans to
refinance debt, convert it into shares, or retire it from a bond retirement fund, it
should continue to report the debt as non-current if the refinancing agreement is
completed by the end of the period. [10]

LEARNING OBJECTIVE

Indicate how to present and analyze non-current liabilities.

Note disclosures generally indicate the nature of the liabilities, maturity dates,
interest rates, call provisions, conversion privileges, restrictions imposed by the
creditors, and assets designated or pledged as security. Companies should show
any assets pledged as security for the debt in the assets section of the statement of
financial position. The fair value of the long-term debt should also be disclosed.
Finally, companies must disclose future payments for sinking fund requirements and
maturity amounts of long-term debt during each of the next five years. These
disclosures aid financial statement users in evaluating the amounts and timing of
future cash flows. Illustration 14-25 shows an example of the type of information
provided for Novartis Group.
ILLUSTRATION 14-25
Long-Term Debt Disclosure

Analysis of Non-Current Liabilities

Long-term creditors and shareholders are interested in a company's long-run

solvency, particularly its ability to pay interest as it comes due and to repay the
face value of the debt at maturity. Debt to assets and times interest earned are two
ratios that provide information about debt-paying ability and long-run solvency.

Debt to Assets Ratio. The debt to assets ratio measures the percentage of the
total assets provided by creditors. To compute it, divide total debt (both current and
non-current liabilities) by total assets, as Illustration 14-26 shows.

ILLUSTRATION 14-26
Computation of Debt to Assets Ratio

The higher the percentage of total liabilities to total assets, the greater the risk that
the company may be unable to meet its maturing obligations.

Times Interest Earned. The times interest earned ratio indicates the
company's ability to meet interest payments as they come due. As shown
in Illustration 14-27, it is computed by dividing income before interest expense and
income taxes by interest expense.

ILLUSTRATION 14-27
Computation of Times Interest Earned

To illustrate these ratios, we use data from Novartis's 2012 annual report. Novartis
has total liabilities of $54,997 million, total assets of $124,216 million, interest
expense of $724 million, income taxes of $1,625 million, and net income of $9,618
million. We compute Novartis's debt to assets and times interest earned ratios as
shown in Illustration 14-28.

ILLUSTRATION 14-28
Computation of Long-Term Debt Ratios for Novartis
Even though Novartis has a relatively high debt to assets ratio of 44 percent, its
interest coverage of 16.5 times indicates it can meet its interest payments as they
come due.

GLOBAL ACCOUNTING INSIGHTS

LIABILITIES

U.S. GAAP and IFRS have similar definitions for liabilities. In addition, the accounting
for current liabilities is essentially the same under both IFRS and U.S. GAAP.
However, there are substantial differences in terminology related to non-current
liabilities as well as some differences in the accounting for various types of long-
term debt transactions.

RELEVANT FACTS

Similarities

As indicated above, U.S. GAAP and IFRS have similar liability definitions. Both
also classify liabilities as current and non-current.

Much of the accounting for bonds and long-term notes is the same under U.S.
GAAP and IFRS.

Both U.S. GAAP and IFRS require the best estimate of a probable loss. In U.S.
GAAP, the minimum amount in a range is used. Under IFRS, if a range of
estimates is predicted and no amount in the range is more likely than any
other amount in the range, the midpoint of the range is used to measure the
liability.

Both U.S. GAAP and IFRS prohibit the recognition of liabilities for future
losses.

Differences

Under U.S. GAAP, companies must classify a refinancing as current only if it is

completed before the financial statements are issued. IFRS requires that the
current portion of long-term debt be classified as current unless an
agreement to refinance on a long-term basis is completed before the
reporting date.
 U.S. GAAP uses the term contingency in a different way than IFRS. A
contingency under U.S. GAAP may be reported as a liability under certain
situations. IFRS does not permit a contingency to be recorded as a liability.

U.S. GAAP uses the term estimated liabilities to discuss various liability items
that have some uncertainty related to timing or amount. IFRS generally uses
the term provisions.

U.S. GAAP and IFRS are similar in the treatment of environmental liabilities.
However, the recognition criteria for environmental liabilities are more
stringent under U.S. GAAP: Environmental liabilities are not recognized unless
there is a present legal obligation and the fair value of the obligation can be
reasonably estimated.

U.S. GAAP uses the term troubled debt restructurings and develops
recognition rules related to this category. IFRS generally assumes that all
restructurings should be considered extinguishments of debt.

Under U.S. GAAP, companies are permitted to use the straight-line method of
amortization for bond discount or premium, provided that the amount
recorded is not materially different than that resulting from effective-interest
amortization. However, the effective-interest method is preferred and is
generally used. Under IFRS, companies must use the effective-interest
method.

Under U.S. GAAP, companies record discounts and premiums in separate

accounts (see the About the Numbers section). Under IFRS, companies do not
use premium or discount accounts but instead show the bond at its net
amount.

Under U.S. GAAP, bond issue costs are recorded as an asset. Under IFRS,
bond issue costs are netted against the carrying amount of the bonds.

Under U.S. GAAP, losses on onerous contract are generally not recognized
unless addressed by industry- or transaction-specific requirements. IFRS
requires a liability and related expense or cost be recognized when a contract
is onerous.

ABOUT THE NUMBERS

Under IFRS, premiums and discounts are netted against the face value of the bonds
for recording purposes. Under U.S. GAAP, discounts and premiums are recorded in
separate accounts. To illustrate, consider the 100,000 of bonds dated January 1,
2015 (8 percent coupon, paid semiannually), issued by Evermaster to yield 6
percent on January 1, 2015. Recall from the discussion on page 661 that the price of
these bonds was 108,530. Using U.S. GAAP procedures, Evermaster makes the
following entry to record issuance of the bonds.

As indicated, the bond premium is recorded in a separate account (the account,

Discount on Bonds Payable, has a debit balance and is used for bonds issued at a
discount). Evermaster makes the following entry on the first interest payment date.

Following this entry, the net carrying value of the bonds is as follows.

Thus, with a separate account for the premium, entries to record amortization are
made to the premium account, which reduces the carrying value of the bonds to
face value over the life of the bonds.

ON THE HORIZON

As indicated in Chapter 2, the IASB and FASB are working on a conceptual

framework project, part of which will examine the definition of a liability. In addition,
the two Boards are attempting to clarify the accounting related to provisions and
related contingencies.

KEY TERMS

amortization, 659

bearer (coupon) bonds, 655

bond discount, 657

bond indenture, 654

bond premium, 657

callable bonds, 655

carrying value, 659

commodity-backed bonds, 655

convertible bonds, 655

debenture bonds, 655

debt to assets ratio, 681

deep-discount (zero-interest debenture) bonds, 655

effective-interest method, 659

effective yield or market rate, 657

extinguishment of debt, 671

face, par, principal, or maturity value, 656

fair value option, 676

imputation, 669

imputed interest rate, 669

income bonds, 655

long-term debt, 654

long-term notes payable, 665

mortgage notes payable, 670

off-balance-sheet financing, 677

refunding, 673

registered bonds, 655

revenue bonds, 655

secured bonds, 655

serial bonds, 655

special purpose entity (SPE), 677

stated, coupon, or nominal rate, 656

substantial modification, 674 (n)

term bonds, 655

times interest earned, 681

zero-interest debenture bonds, 655

SUMMARY OF LEARNING OBJECTIVES

Describe the formal procedures associated with issuing long-term

debt. Incurring long-term debt is often a formal procedure. The bylaws of
corporations usually require approval by the board of directors and the shareholders
before corporations can issue bonds or can make other long-term debt
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.

Identify various types of bond issues. Various types of bond issues are (1)
secured and unsecured bonds; (2) term, serial, and callable bonds; (3) convertible,
commodity-backed, and deep-discount bonds; (4) registered and bearer (coupon)
bonds; and (5) income and revenue bonds. The variety in the types of bonds results
from attempts to attract capital from different investors and risk-takers and to
satisfy the cash flow needs of the issuers.

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

Apply the methods of bond discount and premium amortization. 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 decreases bond interest expense. The procedure for
amortization of a discount or premium is the effective-interest method. Under the
effective-interest method, (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; then, (2) the bond discount or premium amortization is determined by
comparing the bond interest expense with the interest to be paid.
 Explain the accounting for long-term notes payable. 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, a company must evaluate the entire arrangement in
order to properly record the exchange and the subsequent interest.

Describe the accounting for the extinguishment of non-current

liabilities. Non-current liabilities, such as bonds and notes payable, may be
extinguished by (1) paying cash, (2) transferring non-cash assets and/or granting of
an equity interest, and (3) modification of terms. At the time of extinguishment, any
unamortized premium or discount 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 carrying amount of the debt is the amount payable at maturity, adjusted
for unamortized premium or discount. Any excess of the carrying amount over the
reacquisition price is a gain from extinguishment. The excess of the reacquisition
price over the carrying amount is a loss from extinguishment. Gains and losses on
extinguishments are recognized currently in income. When debt is extinguished by
transfer of non-cash assets or granting of equity interest, debtors record losses and
gains on settlements based on fair values. The accounting for debt extinguished
with modification is similar to that for other extinguishments. That is, the original
obligation is extinguished, the new payable is recorded at fair value, and a gain or
loss is recognized for the difference in the fair value of the new obligation and the
carrying value of the old obligation.

Describe the accounting for the fair value option. Companies have the
option to record fair value in their accounts for most financial assets and liabilities,
including non-current liabilities. Fair value measurement for financial instruments,
including financial liabilities, provides more relevant and understandable
information than amortized cost. If companies choose the fair value option, non-
current liabilities such as bonds and notes payable are recorded at fair value, with
unrealized holding gains or losses reported as part of net income. An unrealized
holding gain or loss is the net change in the fair value of the liability from one period
to another, exclusive of interest expense recognized but not recorded.

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

balance-sheet financing is an attempt to borrow funds in such a way as to prevent
recording obligations. Examples of off-balance-sheet arrangements are (1) non-
consolidated subsidiaries, (2) special purpose entities, and (3) operating leases.

Indicate how to present and analyze non-current liabilities. Companies

that have large amounts and numerous issues of non-current liabilities frequently
report only one amount in the statement of financial position and support this with
comments and schedules in the accompanying notes. Any assets pledged as
security for the debt should be shown in the assets section of the statement of
financial position. Long-term debt that matures within one year should be reported
as a current liability, unless retirement is to be accomplished with other than
current assets. If a company plans to refinance the debt, convert it into shares, or
retire it from a bond retirement fund, it should continue to report it as non-current,
as long as the refinancing is completed by the end of the period. Disclosure is
required of future payments for sinking fund requirements and maturity amounts of
long-term debt during each of the next five years. Debt to assets and times interest
earned are two ratios that provide information about a company's debt-paying
ability and long-run solvency.

IFRS AUTHORITATIVE LITERATURE

Authoritative Literature References

[1] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), par. 47.

[2] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), par. 43.

[3] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), paras. AG6465.

[4] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), paras. AG5961.

[5] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), par. AG62.

[6] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), par. 40.

[7] International Accounting Standard 39, Financial Instruments: Recognition and

Measurement (London, U.K.: International Accounting Standards Committee
Foundation, 2003), paras. IN1617.

[8] International Financial Reporting Standard 9, Financial Instruments (London,

U.K.: IFRS Foundation, November 2013), paras. 5.7.75.7.8.
[9] International Financial Reporting Standard 10, Consolidated Financial
Statements (London, U.K.: International Accounting Standards Committee
Foundation, May 2011), paras. IN8IN9.

[10] International Accounting Standard 1, Presentation of Financial

Statements (London, U.K.: International Accounting Standards Committee
Foundation, 2003), paras. 6976.

1. From what sources might a corporation obtain funds through long-term debt?
(b) What is a bond indenture? What does it contain? (c)What is a mortgage?

2. Novartis Group (CHE) has issued various types of bonds such as term
bonds, income bonds, and debentures. Differentiate between term bonds,
mortgage bonds, collateral trust bonds, debenture bonds, income bonds,
callable bonds, registered bonds, bearer or coupon bonds, convertible bonds,
commodity-backed bonds, and deep-discount bonds.

3. Distinguish between the following interest rates for bonds payable:

1. (a) Yield rate.

2. (b) Nominal rate.

3. (c) Stated rate.

4. Distinguish between the following values relative to bonds payable:

1. (a) Maturity value.

2. (b) Face value.

5. Under what conditions of bond issuance does a discount on bonds payable

arise? Under what conditions of bond issuance does a premium on bonds
payable arise?

6. Briefly explain how bond premium or discount affects interest expense over
the life of a bond.

7. What is the required method of amortizing discount and premium on bonds

payable? Explain the procedures.

8. Zopf Company sells its bonds at a premium and applies the effective-interest
method in amortizing the premium. Will the annual interest expense increase
or decrease over the life of the bonds? Explain.
 9. Vodafone (GBR) recently issued debt. How should the costs of issuing these
bonds be accounted for?

10.Will the amortization of a bond discount increase or decrease bond interest

expense? Explain.

11.What is done to record properly a transaction involving the issuance of a non-

interest-bearing long-term note in exchange for property?

12.How is the present value of a non-interest-bearing note computed?

13.When is the stated interest rate of a debt instrument presumed to be fair?

14.What are the considerations in imputing an appropriate interest rate?

15.Differentiate between a fixed-rate mortgage and a variable-rate mortgage.

16.Identify the situations under which debt is extinguished.

17.What is the call feature of a bond issue? How does the call feature affect
the amortization of bond premium or discount?

18.Why would a company wish to reduce its bond indebtedness before its bonds
reach maturity? Indicate how this can be done and the correct accounting
treatment for such a transaction.

19.What are the general rules for measuring a gain or a loss by a debtor in a
debt extinguishment?

20.(a) In a debt modification situation, why might the creditor grant concessions
to the debtor?

(b) What type of concessions might a creditor grant the debtor in a debt
modification situation?

21.What are the general rules for measuring and recognizing gain or loss by a
debt extinguishment with modification?

22.What is the fair value option? Briefly describe the controversy of applying the
fair value option to financial liabilities.

23.Pierre Company has a 12% note payable with a carrying value of 20,000.
Pierre applies the fair value option to this note; given an increase in market
interest rates, the fair value of the note is 22,600. Prepare the entry to
record the fair value option for this note.

24.What disclosures are required relative to long-term debt and sinking fund
requirements?
 25.What is off-balance-sheet financing? Why might a company be interested in
using off-balance-sheet financing?

26.What are some forms of off-balance-sheet financing?

27.Explain how a non-consolidated subsidiary can be a form of off-balance-sheet

financing.

28. Briefly describe some of the similarities and differences between U.S.
GAAP and IFRS with respect to the accounting for liabilities.

29. Diaz Company issued $100,000 face value, 9% coupon bonds on January
1, 2014, for $92,608 to yield 11%. The bonds mature in 5 years and pay
interest annually on December 31. Prepare the entries under U.S. GAAP for
Diaz for (a) date of issue, (b) first interest payment date, and (c) January 1,
2016, when Diaz calls and extinguishes the bonds at 101.

30.Briefly discuss how accounting convergence efforts addressing liabilities are

related to the IASB/FASB conceptual framework project.

(All calculations are to be rounded to nearest whole currency unit, unless

otherwise stated).

BE14-1 Whiteside Corporation issues 500,000 of 9% bonds, due in 10 years,

with interest payable semiannually. At the time of issue, the market rate for such
bonds is 10%. Compute the issue price of the bonds.

BE14-2 The Colson Company issued 300,000 of 10% bonds on January 1,

2015. The bonds are due January 1, 2020, with interest payable each July 1 and
January 1. The bonds are issued at face value. Prepare Colson's journal entries for
(a) the January issuance, (b) the July 1 interest payment, and (c) the December 31
adjusting entry.

BE14-3 Assume the bonds in BE14-2 were issued at 108.11 to yield 8%.
Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31.

BE14-4 Assume the bonds in BE14-2 were issued at 92.6393 to yield 12%.
Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31.
 BE14-5 Devers Corporation issued 400,000 of 6% bonds on May 1, 2015.
The bonds were dated January 1, 2015, and mature January 1, 2017, with interest
payable July 1 and January 1. The bonds were issued at face value plus accrued
interest. Prepare Devers' journal entries for (a) the May 1 issuance, (b) the July 1
interest payment, and (c) the December 31 adjusting entry.

BE14-6 On January 1, 2015, JWS Corporation issued $600,000 of 7% bonds,

due in 10 years. The bonds were issued for $559,224, and pay interest each July 1
and January 1. Prepare the company's journal entries for (a) the January 1 issuance,
(b) the July 1 interest payment, and (c) the December 31 adjusting entry. Assume an
effective-interest rate of 8%.

BE14-7 Assume the bonds in BE14-6 were issued for $644,636 with the
effective-interest rate of 6%. Prepare the company's journal entries for (a) the
January 1 issuance, (b) the July 1 interest payment, and (c) the December 31
adjusting entry.

BE14-8 Tan Corporation issued HK$600,000,000 of 7% bonds on November

1, 2015, for HK$644,636,000. The bonds were dated November 1, 2015, and mature
in 10 years, with interest payable each May 1 and November 1. The effective-
interest rate is 6%. Prepare Tan's December 31, 2015, adjusting entry.

BE14-9 Coldwell, Inc. issued a 100,000, 4-year, 10% note at face value to Flint
Hills Bank on January 1, 2015, and received 100,000 cash. The note requires
annual interest payments each December 31. Prepare Coldwell's journal entries to
record (a) the issuance of the note and (b) the December 31 interest payment.

BE14-10 Samson Corporation issued a 4-year, 75,000, zero-interest-bearing

note to Brown Company on January 1, 2015, and received cash of 47,664. The
implicit interest rate is 12%. Prepare Samson's journal entries for (a) the January 1
issuance and (b) the December 31 recognition of interest.

BE14-11 McCormick Corporation issued a 4-year, $40,000, 5% note to

Greenbush Company on January 1, 2015, and received a computer that normally
sells for $31,495. The note requires annual interest payments each December 31.
The market rate of interest for a note of similar risk is 12%. Prepare McCormick's
journal entries for (a) the January 1 issuance and (b) the December 31 interest.

BE14-12 Shlee Corporation issued a 4-year, 60,000, zero-interest-bearing note

to Garcia Company on January 1, 2015, and received cash of 60,000. In addition,
Shlee agreed to sell merchandise to Garcia at an amount less than regular selling
price over the 4-year period. The market rate of interest for similar notes is 12%.
Prepare Shlee Corporation's January 1 journal entry.
 BE14-13 On January 1, 2015, Henderson Corporation retired $500,000 of bonds
at 99. At the time of retirement, the unamortized premium was $15,000. Prepare
Henderson's journal entry to record the reacquisition of the bonds.

BE14-14 Refer to the note issued by Coldwell, Inc. in BE14-9. During 2015,
Coldwell experiences financial difficulties. On January 1, 2016, Coldwell negotiates a
settlement of the note by issuing to Flint Hills Bank 20,000 1 par Coldwell ordinary
shares. The ordinary shares have a market price of 4.75 per share on the date of
the settlement. Prepare Coldwell's entries to settle this note.

BE14-15 Refer to the note issued by Coldwell, Inc. in BE14-9. During 2015,
Coldwell experiences financial difficulties. On January 1, 2016, Coldwell negotiates a
modification of the terms of the note. Under the modification, Flint Hills Bank agrees
to reduce the face value of the note to 90,000 and to extend the maturity date to
January 1, 2020. Annual interest payments on December 31 will be made at a rate
of 8%. Coldwell's market interest rate at the time of the modification is 12%.
Prepare Coldwell's entries for (a)the modification on January 1, 2016, and (b) the
first interest payment date on December 31, 2016.

BE14-16 Shonen Knife Corporation has elected to use the fair value option for
one of its notes payable. The note was issued at an effective rate of 11% and has a
carrying value of HK$16,000. At year-end, Shonen Knife's borrowing rate has
declined; the fair value of the note payable is now HK$17,500. (a) Determine the
unrealized gain or loss on the note. (b) Prepare the entry to record any unrealized
gain or loss, assuming that the change in value was due to general market
conditions.

BE14-17 At December 31, 2015, Hyasaki Corporation has the following account
balances:

Show how the above accounts should be presented on the December 31, 2015,
statement of financial position, including the proper classifications.

(All calculations are to be rounded to nearest whole currency unit, unless

otherwise stated).

E14-1 Classification of Liabilities) Presented below are various account

balances.
 1. (a) Bank loans payable of a winery, due March 10, 2018. (The product
requires aging for 5 years before sale.)

2. (b) Serial bonds payable, 1,000,000, of which 250,000 are due each July
31.

3. (c) Amounts withheld from employees' wages for income taxes.

4. (d) Notes payable due January 15, 2017.

5. (e) Credit balances in customers' accounts arising from returns and

allowances after collection in full of account.

6. (f) Bonds payable of 2,000,000 maturing June 30, 2016.

7. (g) Overdraft of 1,000 in a bank account. (No other balances are carried at
this bank.)

8. (h) Deposits made by customers who have ordered goods.

INSTRUCTIONS

Indicate whether each of the items above should be classified on December 31,
2015, as a current liability, a non-current liability, or under some other classification.
Consider each one independently from all others; that is, do not assume that all of
them relate to one particular business. If the classification of some of the items is
doubtful, explain why in each case.

E14-2 (Classification) The following items are found in the financial

statements.

1. (a) Interest expense (credit balance).

2. (b) Bond issue costs.

3. (c) Gain on repurchase of debt.

4. (d) Mortgage payable (payable in equal amounts over next 3 years).

5. (e) Debenture bonds payable (maturing in 5 years).

6. (f) Notes payable (due in 4 years).

7. (g) Income bonds payable (due in 3 years).

INSTRUCTIONS

Indicate how each of these items should be classified in the financial statements.
 E14-3 (Entries for Bond Transactions) Presented below are two
independent situations.

1. 1. On January 1, 2015, Divac Company issued 300,000 of 9%, 10-year bonds

at par. Interest is payable quarterly on April 1, July 1, October 1, and January
1.

2. 2. On June 1, 2015, Verbitsky Company issued 200,000 of 12%, 10-year

bonds dated January 1 at par plus accrued interest. Interest is payable
semiannually on July 1 and January 1.

INSTRUCTIONS

For each of these two independent situations, prepare journal entries to record the
following.

1. (a) The issuance of the bonds.

2. (b) The payment of interest on July 1.

3. (c) The accrual of interest on December 31.

E14-4 (Entries for Bond Transactions) Foreman Company issued

800,000 of 10%, 20-year bonds on January 1, 2015, at 119.792 to yield 8%.
Interest is payable semiannually on July 1 and January 1.

INSTRUCTIONS

Prepare the journal entries to record the following.

1. (a) The issuance of the bonds.

2. (b) The payment of interest and the related amortization on July 1, 2015.

3. (c) The accrual of interest and the related amortization on December 31,
2015.

E14-5 (Entries for Bond Transactions) Assume the same information as

in E14-4, except that the bonds were issued at 84.95 to yield 12%.

INSTRUCTIONS

Prepare the journal entries to record the following. (Round to the nearest euro.)

1. (a) The issuance of the bonds.

2. (b) The payment of interest and related amortization on July 1, 2015.

 3. (c) The accrual of interest and the related amortization on December 31,
2015.

E14-6 (Amortization Schedule) Spencer Company sells 10% bonds

having a maturity value of 3,000,000 for 2,783,724. The bonds are dated January
1, 2015, and mature January 1, 2020. Interest is payable annually on January 1.

INSTRUCTIONS

Set up a schedule of interest expense and discount amortization. (Hint: The

effective-interest rate must be computed.)

E14-7 (Determine Proper Amounts in Account Balances) Presented

below are three independent situations.

INSTRUCTIONS

1. (a) McEntire Co. sold $2,500,000 of 11%, 10-year bonds at 106.231 to yield
10% on January 1, 2015. The bonds were dated January 1, 2015, and pay
interest on July 1 and January 1. Determine the amount of interest expense to
be reported on July 1, 2015, and December 31, 2015.

2. (b) Cheriel Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2015, for
$562,500. This price provided a yield of 10% on the bonds. Interest is payable
semiannually on December 31 and June 30. Determine the amount of interest
expense to record if financial statements are issued on October 31, 2015.

3. (c) On October 1, 2015, Chinook Company sold 12% bonds having a maturity
value of $800,000 for $853,382 plus accrued interest, which provides the
bondholders with a 10% yield. The bonds are dated January 1, 2015, and
mature January 1, 2020, with interest payable December 31 of each year.
Prepare the journal entries at the date of the bond issuance and for the first
interest payment.

E14-8 (Entries and Questions for Bond Transactions) On June 30,

2014, Macias Company issued R$5,000,000 face value of 13%, 20-year bonds at
R$5,376,150 to yield 12%. The bonds pay semiannual interest on June 30 and
December 31.

INSTRUCTIONS
 1. (a) Prepare the journal entries to record the following transactions.

(1) The issuance of the bonds on June 30, 2014.

(2) The payment of interest and the amortization of the premium on December 31,
2014.

(3) The payment of interest and the amortization of the premium on June 30, 2015.

(4) The payment of interest and the amortization of the premium on December 31,
2015.

2. (b) Show the proper statement of financial position presentation for the
liability for bonds payable on the December 31, 2015, statement of financial
position.

3. (c) Provide the answers to the following questions.

(1) What amount of interest expense is reported for 2015?

(2) Determine the total cost of borrowing over the life of the bond.

E14-9 (Entries for Bond Transactions) On January 1, 2015, Osborn

Company sold 12% bonds having a maturity value of 800,000 for 860,651.79,
which provides the bondholders with a 10% yield. The bonds are dated January 1,
2015, and mature January 1, 2020, with interest payable December 31 of each year.

INSTRUCTIONS

1. (a) Prepare the journal entry at the date of the bond issuance.

2. (b) Prepare a schedule of interest expense and bond amortization for 2015
2017.

3. (c) Prepare the journal entry to record the interest payment and the
amortization for 2015.

4. (d) Prepare the journal entry to record the interest payment and the
amortization for 2017.

E14-10 (Information Related to Various Bond Issues) Pawnee Inc. has

issued three types of debt on January 1, 2015, the start of the company's fiscal year.

1. (a) $10 million, 10-year, 13% unsecured bonds, interest payable quarterly.
Bonds were priced to yield 12%.

2. (b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per
year.
 3. (c) $15 million, 10-year, 10% mortgage bonds, interest payable annually to
yield 12%.

INSTRUCTIONS

Prepare a schedule that identifies the following items for each bond: (1) maturity
value, (2) number of interest periods over life of bond, (3) stated rate per each
interest period, (4) effective-interest rate per each interest period, (5) payment
amount per period, and (6) present value of bonds at date of issue.

E14-11 (Entries for Zero-Interest-Bearing Notes) On January 1, 2015,

McLean Company makes the two following acquisitions.

1. Purchases land having a fair value of 300,000 by issuing a 5-year, zero-

interest-bearing promissory note in the face amount of 505,518.

2. Purchases equipment by issuing a 6%, 8-year promissory note having a

maturity value of 400,000 (interest payable annually).

The company has to pay 11% interest for funds from its bank.

INSTRUCTIONS

1. (a) Record the two journal entries that should be recorded by McLean
Company for the two purchases on January 1, 2015.

2. (b) Record the interest at the end of the first year on both notes.

E14-12 (Imputation of Interest) Presented below are two independent

situations.

INSTRUCTIONS

1. (a) On January 1, 2015, Spartan Inc. purchased land that had an assessed
value of $390,000 at the time of purchase. A $600,000, zero-interest-bearing
note due January 1, 2018, was given in exchange. There was no established
exchange price for the land, nor a ready market price for the note. The
interest rate charged on a note of this type is 12%. Determine at what
amount the land should be recorded at January 1, 2015, and the interest
expense to be reported in 2015 related to this transaction.

2. (b) On January 1, 2015, Geimer Furniture Co. borrowed $4,000,000 (face

value) from Aurora Co., a major customer, through a zero-interest-bearing
note due in 4 years. Because the note was zero-interest-bearing, Geimer
Furniture agreed to sell furniture to this customer at lower than market price.
A 10% rate of interest is normally charged on this type of loan. Prepare the
 journal entry to record this transaction and determine the amount of interest
expense to report for 2015.

E14-13 (Imputation of Interest with Right) On January 1, 2015, Durdil Co.

borrowed and received 500,000 from a major customer evidenced by a zero-
interest-bearing note due in 3 years. As consideration for the zero-interest-bearing
feature, Durdil agrees to supply the customer's inventory needs for the loan period
at lower than the market price. The appropriate rate at which to impute interest is
8%.

INSTRUCTIONS

1. (a) Prepare the journal entry to record the initial transaction on January 1,
2015.

2. (b) Prepare the journal entry to record any adjusting entries needed at
December 31, 2015. Assume that the sales of Durdil's product to this
customer occur evenly over the 3-year period.

E14-14 (Entry for Retirement of Bond; Bond Issue Costs) On January

2, 2012, Prebish Corporation issued $1,500,000 of 10% bonds to yield 11% due
December 31, 2021. Interest on the bonds is payable annually each December 31.
The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2,
2015, Prebish called $1,000,000 face amount of the bonds and retired them.

INSTRUCTIONS

1. (a) Determine the price of the Prebish bonds when issued on January 2, 2012.

2. (b) Prepare an amortization schedule for 20122016 for the bonds.

3. (c) Ignoring income taxes, compute the amount of loss, if any, to be

recognized by Prebish as a result of retiring the $1,000,000 of bonds in 2015
and prepare the journal entry to record the retirement.

E14-15 (Entries for Retirement and Issuance of Bonds) On June 30,

2007, Mendenhal Company issued 8% bonds with a par value of 600,000 due in 20
years. They were issued at 82.8414 to yield 10% and were callable at 104 at any
date after June 30, 2015. Because of lower interest rates and a significant change in
the company's credit rating, it was decided to call the entire issue on June 30, 2016,
and to issue new bonds. New 6% bonds were sold in the amount of 800,000 at
112.5513 to yield 5%; they mature in 20 years. Interest payment dates are
December 31 and June 30 for both old and new bonds.
INSTRUCTIONS

1. (a) Prepare journal entries to record the retirement of the old issue and the
sale of the new issue on June 30, 2016. Unamortized discount is 78,979.

2. (b) Prepare the entry required on December 31, 2016, to record the payment
of the first 6 months' interest and the amortization of premium on the bonds.

E14-16 (Entries for Retirement and Issuance of Bonds) Kobiachi

Company had bonds outstanding with a maturity value of 5,000,000. On April 30,
2016, when these bonds had an unamortized discount of 100,000, they were
called in at 104. To pay for these bonds, Kobiachi had issued other bonds a month
earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years.
The new bonds were issued at 103 (face value 5,000,000).

INSTRUCTIONS

Ignoring interest, compute the gain or loss and record this refunding transaction.

E14-17 (Settlement of Debt) Strickland Company owes $200,000 plus

$18,000 of accrued interest to Moran State Bank. The debt is a 10-year, 10% note.
During 2015, Strickland's business deteriorated due to a faltering regional economy.
On December 31, 2015, Moran State Bank agrees to accept an old machine and
cancel the entire debt. The machine has a cost of $390,000, accumulated
depreciation of $221,000, and a fair value of $180,000.

INSTRUCTIONS

1. (a) Prepare journal entries for Strickland Company to record this debt
settlement.

2. (b) How should Strickland report the gain or loss on the disposition of
machine and on restructuring of debt in its 2015 income statement?

3. (c) Assume that, instead of transferring the machine, Strickland decides to

grant 15,000 of its ordinary shares ($10 par), which have a fair value of
$180,000 in full settlement of the loan obligation. Prepare the entries to
record the transaction.

E14-18 (Loan Modification) On December 31, 2015, Sterling Bank enters into
a debt restructuring agreement with Barkley Company, which is now experiencing
financial trouble. The bank agrees to restructure a 12%, issued at par, 3,000,000
note receivable by the following modifications:

1. Reducing the principal obligation from 3,000,000 to 2,400,000.

 2. Extending the maturity date from December 31, 2015, to January 1, 2019.

3. Reducing the interest rate from 12% to 10%. Barkley's market rate of interest
is 15%.

Barkley pays interest at the end of each year. On January 1, 2019, Barkley Company
pays 2,400,000 in cash to Sterling Bank.

INSTRUCTIONS

1. (a) Can Barkley Company record a gain under the term modification
mentioned above? Explain.

2. (b) Prepare the amortization schedule of the note for Barkley Company after
the debt modification.

3. (c) Prepare the interest payment entry for Barkley Company on December
31, 2017.

4. (d) What entry should Barkley make on January 1, 2019?

E14-19 (Loan Modification) Use the same information as in E14-18 except

that Sterling Bank reduced the principal to 1,900,000 rather than 2,400,000. On
January 1, 2019, Barkley pays 1,900,000 in cash to Sterling Bank for the principal.

INSTRUCTIONS

1. (a) Prepare the journal entries to record the loan modification for Barkley.

2. (b) Prepare the amortization schedule of the note for Barkley Company after
the debt modification.

3. (c) Prepare the interest payment entries for Barkley Company on December
31 of 2016, 2017, and 2018.

4. (d) What entry should Barkley make on January 1, 2019?

E14-20 (Entries for Settlement of Debt) Consider the following independent

situations.

INSTRUCTIONS

1. (a) Gottlieb Co. owes 199,800 to Ceballos Inc. The debt is a 10-year, 11%
note. Because Gottlieb Co. is in financial trouble, Ceballos Inc. agrees to
accept some land and cancel the entire debt. The land has a book value of
90,000 and a fair value of 140,000. Prepare the journal entry on Gottlieb's
books for debt settlement.
 2. (b) Vargo Corp. owes $270,000 to First Trust. The debt is a 10-year, 12% note
due December 31, 2015. Because Vargo Corp. is in financial trouble, First
Trust agrees to extend the maturity date to December 31, 2017, reduce the
principal to $220,000, and reduce the interest rate to 5%, payable annually
on December 31. Vargo's market rate of interest is 8%. Prepare the journal
entries on Vargo's books on December 31, 2015, 2016, and 2017.

E14-21 (Fair Value Option) Fallen Company commonly issues long-term notes
payable to its various lenders. Fallen has had a pretty good credit rating such that
its effective borrowing rate is quite low (less than 8% on an annual basis). Fallen has
elected to use the fair value option for the long-term notes issued to Barclay's Bank
and has the following data related to the carrying and fair value for these notes.
(Assume that changes in fair value are due to general market interest rate
changes).

INSTRUCTIONS

1. (a) Prepare the journal entry at December 31 (Fallen's year-end) for 2015,
2016, and 2017, to record the fair value option for these notes.

2. (b) At what amount will the note be reported on Fallen's 2016 statement of
financial position?

3. (c) What is the effect of recording the fair value option on these notes on
Fallen's 2017 income?

4. (d) Assuming that general market interest rates have been stable over the
period, does the fair value data for the notes indicate that Fallen's
creditworthiness has improved or declined in 2017? Explain.

5. (e) Assuming the conditions that exist in (d), what is the effect of recording
the fair value option on these notes in Fallen's income statement in 2015,
2016, and 2017?

E14-22 (Long-Term Debt Disclosure) At December 31, 2015, Redmond

Company has outstanding three long-term debt issues. The first is a $2,000,000
note payable which matures June 30, 2018. The second is a $6,000,000 bond issue
which matures September 30, 2019. The third is a $12,500,000 sinking fund
debenture with annual sinking fund payments of $2,500,000 in each of the years
2017 through 2021.

INSTRUCTIONS
Prepare the required note disclosure for the long-term debt at December 31, 2015.

(All calculations are to be rounded to nearest whole currency unit, unless

otherwise stated).

P14-1 (Analysis of Amortization Schedule and Interest

Entries) The amortization and interest schedule on page 692 reflects the issuance
of 10-year bonds by Capulet Corporation on January 1, 2009, and the subsequent
interest payments and charges. The company's year-end is December 31, and
financial statements are prepared once yearly.

INSTRUCTIONS

1. (a) Indicate whether the bonds were issued at a premium or a discount and
how you can determine this fact from the schedule.

2. (b) Determine the stated interest rate and the effective-interest rate.

3. (c) On the basis of the schedule, prepare the journal entry to record the
issuance of the bonds on January 1, 2009.

4. (d) On the basis of the schedule, prepare the journal entry or entries to
reflect the bond transactions and accruals for 2009. (Interest is paid January
1.)

5. (e) On the basis of the schedule, prepare the journal entry or entries to
reflect the bond transactions and accruals for 2016. Capulet Corporation does
not use reversing entries.
 P14-2 (Issuance and Retirement of Bonds) Venzuela Co. is building a
new hockey arena at a cost of $2,500,000. It received a down payment of $500,000
from local businesses to support the project and now needs to borrow $2,000,000 to
complete the project. It therefore decides to issue $2,000,000 of 10.5%, 10-year
bonds. These bonds were issued on January 1, 2014, and pay interest annually on
each January 1. The bonds yield 10%.

INSTRUCTIONS

1. (a) Prepare the journal entry to record the issuance of the bonds on January
1, 2014.

2. (b) Prepare a bond amortization schedule up to and including January 1,

2018.

3. (c) Assume that on July 1, 2017, Venzuela Co. retires half of the bonds at a
cost of $1,065,000 plus accrued interest. Prepare the journal entry to record
this retirement.

P14-3 (Negative Amortization) Good-Deal Inc. developed a new sales

gimmick to help sell its inventory of new automobiles. Because many new car
buyers need financing, Good-Deal offered a low down payment and low car
payments for the first year after purchase. It believes that this promotion will bring
in some new buyers.

On January 1, 2015, a customer purchased a new 33,000 automobile, making a

down payment of 1,000. The customer signed a note indicating that the annual
rate of interest would be 8% and that quarterly payments would be made over 3
years. For the first year, Good-Deal required a 400 quarterly payment to be made
on April 1, July 1, October 1, and January 1, 2016. After this one-year period, the
customer was required to make regular quarterly payments that would pay off the
loan as of January 1, 2018.

INSTRUCTIONS

1. (a) Prepare a note amortization schedule for the first year.

2. (b) Indicate the amount the customer owes on the contract at the end of the
first year.

3. (c) Compute the amount of the new quarterly payments.

4. (d) Prepare a note amortization schedule for these new payments for the
next 2 years.

5. (e) What do you think of the new sales promotion used by Good-Deal?
 P14-4 (Effective-Interest Method) Samantha Cordelia, an
intermediate accounting student, is having difficulty amortizing bond premiums and
discounts using the effective-interest method. Furthermore, she cannot understand
why IFRS requires that this method be used. She has come to you with the following
problem, looking for help.

On June 30, 2015, Hobart Company issued R$2,000,000 face value of 11%, 20-year
bonds at R$2,171,600, a yield of 10%. Hobart Company uses the effective-interest
method to amortize bond premiums or discounts. The bonds pay semiannual
interest on June 30 and December 31. Compute the amortization schedule for four
periods.

INSTRUCTIONS

Using the data above for illustrative purposes, write a short memo (11.5 pages
double-spaced) to Samantha, explaining what the effective-interest method is, why
it is preferable, and how it is computed. (Do not forget to include an amortization
schedule, referring to it whenever necessary.)

P14-5 (Entries for Zero-Interest-Bearing Note) On December 31, 2015,

Faital Company acquired a computer from Plato Corporation by issuing a 600,000
zero-interest-bearing note, payable in full on December 31, 2019. Faital Company's
credit rating permits it to borrow funds from its several lines of credit at 10%. The
computer is expected to have a 5-year life and a 70,000 residual value.

INSTRUCTIONS

1. (a) Prepare the journal entry for the purchase on December 31, 2015.

2. (b) Prepare any necessary adjusting entries relative to depreciation (use

straight-line) and amortization on December 31, 2016.

3. (c) Prepare any necessary adjusting entries relative to depreciation and

amortization on December 31, 2017.

P14-6 (Entries for Zero-Interest-Bearing Note; Payable in

Installments) Sabonis Cosmetics Co. purchased machinery on December 31, 2014,
paying $50,000 down and agreeing to pay the balance in four equal installments of
$40,000 payable each December 31. An assumed interest of 8% is implicit in the
purchase price.

INSTRUCTIONS

Prepare the journal entries that would be recorded for the purchase and for the
payments and interest on the following dates.
 P14-4 (Issuance and Retirement of Bonds; Income Statement
Presentation) Chen Company issued its 9%, 25-year mortgage bonds in the
principal amount of 30,000,000 on January 2, 2001, at a discount of 2,722,992
(effective rate of 10%). The indenture securing the issue provided that the bonds
could be called for redemption in total but not in part at any time before maturity at
104% of the principal amount, but it did not provide for any sinking fund.

On December 18, 2015, the company issued its 11%, 20-year debenture bonds in
the principal amount of 40,000,000 at 102, and the proceeds were used to redeem
the 9%, 25-year mortgage bonds on January 2, 2016. The indenture securing the
new issue did not provide for any sinking fund or for retirement before maturity. The
unamortized discount at retirement was 1,842,888.

INSTRUCTIONS

1. (a) Prepare journal entries to record the issuance of the 11% bonds and the
retirement of the 9% bonds.

2. (b) Indicate the income statement treatment of the gain or loss from
retirement and the note disclosure required.

P14-8 (Comprehensive Bond Problem) In each of the following

independent cases, the company closes its books on December 31.

1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2015. The bonds pay
interest on September 1 and March 1. The due date of the bonds is
September 1, 2018. The bonds yield 12%. Give entries through December 31,
2016.

2. Titania Co. sells $400,000 of 12% bonds on June 1, 2015. The bonds pay
interest on December 1 and June 1. The due date of the bonds is June 1,
2019. The bonds yield 10%. On October 1, 2016, Titania buys back $120,000
worth of bonds for $126,000 (includes accrued interest). Give entries through
December 1, 2017.

INSTRUCTIONS

For the two cases, prepare all of the relevant journal entries from the time of sale
until the date indicated. (Construct amortization tables where applicable.) Amortize
premium or discount on interest dates and at year-end. (Assume that no reversing
entries were made; round to the nearest dollar.)
 P14-9 (Issuance of Bonds Between Interest Dates,
Retirement) Presented below are selected transactions on the books of Simonson
Corporation.

INSTRUCTIONS

Prepare journal entries for the transactions above.

P14-10 (Entries for Life Cycle of Bonds) On April 1, 2015, Sarkar

Company sold 15,000 of its 11%, 15-year, R$1,000 face value bonds to yield 12%.
Interest payment dates are April 1 and October 1. On April 2, 2016, Sarkar took
advantage of favorable prices of its shares to extinguish 6,000 of the bonds by
issuing 200,000 of its R$10 par value ordinary shares. At this time, the accrued
interest was paid in cash. The company's shares were selling for R$31 per share on
April 2, 2016.

INSTRUCTIONS

Prepare the journal entries needed on the books of Sarkar Company to record the
following.

1. (a) April 1, 2015: issuance of the bonds.

2. (b) October 1, 2015: payment of semiannual interest.

3. (c) December 31, 2015: accrual of interest expense.

4. (d) April 2, 2016: extinguishment of 6,000 bonds. (No reversing entries

made.)

P14-11 (Modification of Debt) Daniel Perkins is the sole shareholder of

Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a
debtor in possession, he has negotiated the following revised loan agreement with
United Bank. Perkins Inc.'s $600,000, 12%, 10-year note was refinanced with a
$600,000, 5%, 10-year note. Perkins has a market rate of interest of 15%.

INSTRUCTIONS

1. (a) What is the accounting nature of this transaction?

2. (b) Prepare the journal entry to record this refinancing on the books of
Perkins Inc.

P14-12 (Modification of Note under Different Circumstances) Halvor

Corporation is having financial difficulty and therefore has asked Frontenac National
Bank to restructure its $5 million note outstanding. The present note has 3 years
remaining and pays a current rate of interest of 10%. The present market rate for a
loan of this nature is 12%. The note was issued at its face value.

INSTRUCTIONS

Presented below are three independent situations. Prepare the journal entry that
Halvor would make for each of these restructurings.

1. (a) Frontenac National Bank agrees to take an equity interest in Halvor by

accepting ordinary shares valued at $3,700,000 in exchange for relinquishing
its claim on this note. The ordinary shares have a par value of $1,700,000.

2. (b) Frontenac National Bank agrees to accept land in exchange for

relinquishing its claim on this note. The land has a book value of $3,250,000
and a fair value of $4,000,000.

3. (c) Frontenac National Bank agrees to modify the terms of the note,
indicating that Halvor does not have to pay any interest on the note over the
3-year period.

P14-13 (Debtor/Creditor Entries for Continuation of Debt with New

Effective Interest) Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the
amount of 330,000 plus 33,000 of accrued interest. The note is due today,
December 31, 2015. Because Crocker Corp. is in financial trouble, D. Yaeger Corp.
agrees to forgive the accrued interest, 30,000 of the principal and to extend the
maturity date to December 31, 2018. Interest at 10% of revised principal will
continue to be due on 12/31 each year. Given Crocker's financial difficulties, the
market rate for its loans is 12%.

INSTRUCTIONS

1. (a) Prepare the amortization schedule for the years 2015 through 2018.
 2. (b) Prepare all the necessary journal entries on the books of Crocker Corp. for
the years 2015, 2016, and 2017.

P14-14 (Comprehensive Problem: Issuance, Classification,

Reporting) Presented below are three independent situations.

INSTRUCTIONS

1. (a) On January 1, 2015, Langley Co. issued 9% bonds with a face value of
$700,000 for $656,992 to yield 10%. The bonds are dated January 1, 2015,
and pay interest annually. What amount is reported for interest expense in
2015 related to these bonds?

2. (b) Tweedie Building Co. has a number of long-term bonds outstanding at

December 31, 2015. These long-term bonds have the following sinking fund
requirements and maturities for the next 6 years.

Indicate how this information should be reported in the financial statements at

December 31, 2015.

3. (c) In the long-term debt structure of Beckford Inc., the following three bonds
were reported: mortgage bonds payable $10,000,000; collateral trust bonds
$5,000,000; bonds maturing in installments, secured by plant equipment
$4,000,000. Determine the total amount, if any, of debenture bonds
outstanding.

CA14-1 (Bond Theory: Statement of Financial Position Presentations,

Interest Rate, Premium) On January 1, 2016, Nichols Company issued for
$1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and
pay interest semiannually on January 1 and July 1. Bond issue costs were not
material in amount. Below are three presentations of the non-current liability
section of the statement of financial position that might be used for these bonds at
the issue date.
INSTRUCTIONS

1. (a) Discuss the conceptual merit(s) of each of the date-of-issue statement of

financial position presentations shown above for these bonds.

2. (b) Explain why investors would pay $1,085,800 for bonds that have a
maturity value of only $1,000,000.

3. (c) Assuming that a discount rate is needed to compute the carrying value of
the obligations arising from a bond issue at any date during the life of the
bonds, discuss the conceptual merit(s) of using for this purpose:

(1) The coupon or nominal rate.

(2) The effective or yield rate at date of issue.

4. (d) If the obligations arising from these bonds are to be carried at their
present value computed by means of the current market rate of interest, how
would the bond valuation at dates subsequent to the date of issue be
affected by an increase or a decrease in the market rate of interest?

CA14-2 (Various Non-Current Liability Conceptual Issues) Schrempf

Company has completed a number of transactions during 2015. In January, the
company purchased under contract a machine at a total price of 1,200,000,
payable over 5 years with installments of 240,000 per year. The seller has
considered the transaction as an installment sale with the title transferring to
Schrempf at the time of the final payment.

On March 1, 2015, Schrempf issued 10 million of general revenue bonds priced at

99 with a coupon of 10% payable July 1 and January 1 of each of the next 10 years.
The July 1 interest was paid and on December 30, the company transferred
1,000,000 to the trustee, Flagstad Company, for payment of the January 1, 2016,
interest.
As the accountant for Schrempf Company, you have prepared the statement of
financial position as of December 31, 2015, and have presented it to the president
of the company. You are asked the following questions about it.

1. Why has depreciation been charged on equipment being purchased under

contract? Title has not passed to the company as yet and, therefore, it is not
our asset. Why should the company not show on the left side of the
statement of financial position only the amount paid to date instead of
showing the full contract price on the left side and the unpaid portion on the
right side? After all, the seller considers the transaction an installment sale.

2. Bond interest is shown as a current liability. Did we not pay our trustee,
Flagstad Company, the full amount of interest due this period?

INSTRUCTIONS

Outline your answers to these questions by writing a brief paragraph that will justify
your treatment.

CA14-3 (Bond Theory: Price, Presentation, and Retirement) On March 1,

2016, Sealy Company sold its 5-year, 1,000 face value, 9% bonds dated March 1,
2016, at an effective annual interest rate (yield) of 11%. Interest is payable
semiannually, and the first interest payment date is September 1, 2016. Sealy uses
the effective-interest method of amortization. The bonds can be called by Sealy at
101 at any time on or after March 1, 2017.

INSTRUCTIONS

1. (a) (1) How would the selling price of the bond be determined?

(2) Specify how all items related to the bonds would be presented in a statement of
financial position prepared immediately after the bond issue was sold.

2. (b) What items related to the bond issue would be included in Sealy's 2016
income statement, and how would each be determined?

3. (c) Would the amount of bond discount amortization using the effective-
interest method of amortization be lower in the second or third year of the
life of the bond issue? Why?

4. (d) Assuming that the bonds were called in and extinguished on March 1,
2017, how should Sealy report the retirement of the bonds on the 2017
income statement?

CA14-4 (Bond Theory: Amortization and Gain or Loss Recognition)

Part I: The required method of amortizing a premium or discount on issuance of

bonds is the effective-interest method.
INSTRUCTIONS

How is amortization computed using the effective-interest method, and why and
how do amounts obtained using the effective-interest method provide financial
statement readers useful information about the cost of borrowing?

Part II: Gains or losses from the early extinguishment of debt that is refunded can
theoretically be accounted for in three ways:

1. 1. Amortized over remaining life of old debt.

2. 2. Amortized over the life of the new debt issue.

3. 3. Recognized in the period of extinguishment.

Instructions

1. (a) Develop supporting arguments for each of the three theoretical methods
of accounting for gains and losses from the early extinguishment of debt.

2. (b) Which of the methods above is generally accepted under IFRS and how
should the appropriate amount of gain or loss be shown in a company's
financial statements?

CA14-5 (Off-Balance-Sheet Financing) Matt Ryan Corporation is

interested in building its own soda can manufacturing plant adjacent to its existing
plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans
at a stable price and to minimize transportation costs. However, the company has
been experiencing some financial problems and has been reluctant to borrow any
additional cash to fund the project. The company is not concerned with the cash
flow problems of making payments but rather with the impact of adding additional
long-term debt to its statement of financial position.

The president of Ryan, Andy Newlin, approached the president of the Aluminum Can
Company (ACC), its major supplier, to see if some agreement could be reached. ACC
was anxious to work out an arrangement since it seemed inevitable that Ryan would
begin its own can production. Aluminum Can Company could not afford to lose the
account.

After some discussion, a two-part plan was worked out. First, ACC was to construct
the plant on Ryan's land adjacent to the existing plant. Second, Ryan would sign a
20-year purchase agreement. Under the purchase agreement, Ryan would express
its intention to buy all of its cans from ACC, paying a unit price which at normal
capacity would cover labor and material, an operating management fee, and the
debt service requirements on the plant. The expected unit price, if transportation
costs are taken into consideration, is lower than current market. If Ryan did not take
enough production in any one year and if the excess cans could not be sold at a
high enough price on the open market, Ryan agrees to make up any cash shortfall
so that ACC could make the payments on its debt. The bank will be willing to make a
20-year loan for the plant, taking the plant and the purchase agreement as
collateral. At the end of 20 years, the plant is to become the property of Ryan.

INSTRUCTIONS

1. (a) What are project financing arrangements using special purpose entities?

2. (b) What are take-or-pay contracts?

3. (c) Should Ryan record the plant as an asset together with the related
obligation? If not, should Ryan record an asset relating to the future
commitment?

4. (d) What is meant by off-balance-sheet financing?

CA14-6 (Bond Issue) Donald Lennon is the president, founder, and

majority owner of Wichita Medical Corporation, an emerging medical technology
products company. Wichita is in dire need of additional capital to keep operating and
to bring several promising products to final development, testing, and production.
Donald, as owner of 51% of the outstanding shares, manages the company's
operations. He places heavy emphasis on research and development and long-term
growth. The other principal shareholder is Nina Friendly who, as a non-employee
investor, owns 40% of the shares. Nina would like to deemphasize the R & D
functions and emphasize the marketing function to maximize short-run sales and
profits from existing products. She believes this strategy would raise the market
price of Wichita's shares.

All of Donald's personal capital and borrowing power is tied up in his 51% share
ownership. He knows that any offering of additional shares will dilute his controlling
interest because he won't be able to participate in such an issuance. But, Nina has
money and would likely buy enough shares to gain control of Wichita. She then
would dictate the company's future direction, even if it meant replacing Donald as
president and CEO.

The company already has considerable debt. Raising additional debt will be costly,
will adversely affect Wichita's credit rating, and will increase the company's
reported losses due to the growth in interest expense. Nina and the other minority
shareholders express opposition to the assumption of additional debt, fearing the
company will be pushed to the brink of bankruptcy. Wanting to maintain his control
and to preserve the direction of his company, Donald is doing everything to avoid
a share issuance and is contemplating a large issuance of bonds, even if it means
the bonds are issued with a high effective-interest rate.
INSTRUCTIONS

1. (a) Who are the stakeholders in this situation?

2. (b) What are the ethical issues in this case?

3. (c) What would you do if you were Donald?

FINANCIAL REPORTING PROBLEM

MARKS AND SPENCER PLC (M&S)

The financial statements of M&S (GBR) are presented in Appendix A. The

company's complete annual report, including the notes to the financial statements,
is available online.

Instructions

Refer to M&S's financial statements and the accompanying notes to answer the
following questions.

1. (a) What cash outflow obligations related to the repayment of long-term debt
does M&S have over the next 5 years?

2. (b) M&S indicates that it believes that it has the ability to meet business
requirements in the foreseeable future. Prepare an assessment of its liquidity,
solvency, and financial flexibility using ratio analysis.

COMPARATIVE ANALYSIS CASE

ADIDAS AND PUMA

The financial statements of adidas (DEU) and Puma (DEU) are presented in
Appendices B and C, respectively. The complete annual reports, including the notes
to the financial statements, are available online.

Instructions

Use the companies' financial information to answer the following questions.

1. (a) Compute the debt to assets ratio and the times interest earned for these
two companies. Comment on the quality of these two ratios for both adidas
and Puma.

2. (b) What is the difference between the fair value and the historical cost
(carrying amount) of each company's borrowings at year-end 2012? Why
might a difference exist in these two amounts?
 3. (c) Do these companies have debt issued in foreign countries? Speculate as
to why these companies may use foreign debt to finance their operations.
What risks are involved in this strategy, and how might they adjust for this
risk?

FINANCIAL STATEMENT ANALYSIS CASES

CASE 1 COMMONWEALTH EDISON CO.

The following article about Commonwealth Edison Co. (USA) appeared in the Wall
Street Journal.

Bond Markets

Giant Commonwealth Edison Issue Hits Resale Market With $70 Million Left Over

NEW YORKCommonwealth Edison Co.'s slow-selling new 9% bonds were tossed

onto the resale market at a reduced price with about $70 million still available from
the $200 million offered Thursday, dealers said.

The Chicago utility's bonds, rated double-A by Moody's and double-A-minus by

Standard & Poor's, originally had been priced at 99.803, to yield 9.3% in 5 years.
They were marked down yesterday the equivalent of about $5.50 for each $1,000
face amount, to about 99.25, where their yield jumped to 9.45%.

Instructions

1. (a) How will the development above affect the accounting for Commonwealth
Edison's bond issue?

2. (b) Provide several possible explanations for the markdown and the slow sale
of Commonwealth Edison's bonds.

Case 2 Eurotec

Consider the following events relating to Eurotec's long-term debt in a recent year.

1. The company decided on February 1 to refinance 500 million in short-term

7.4% debt to make it long-term 6%.

2. 780 million of long-term zero-coupon bonds with an effective-interest rate of

10.1% matured July 1 and were paid.

3. On October 1, the company issued 250 million in Australian dollars 6.3%

bonds at 102 and 95 million in Italian lira 11.4% bonds at 99.

4. The company holds 100 million in perpetual foreign interest payment bonds
that were issued in 1989 and presently have a rate of interest of 5.3%. These
bonds are called perpetual because they have no stated due date. Instead, at
 the end of every 10-year period after the bond's issuance, the bondholders
and Eurotec have the option of redeeming the bonds. If either party desires to
redeem the bonds, the bonds must be redeemed. If the bonds are not
redeemed, a new interest rate is set, based on the then-prevailing interest
rate for 10-year bonds. The company does not intend to cause redemption of
the bonds but will reclassify this debt to current next year since the
bondholders could decide to redeem the bonds.

Instructions

1. (a) Consider event 1. What are some of the reasons the company may have
decided to refinance this short-term debt, besides lowering the interest rate?

2. (b) What do you think are the benefits to the investor in purchasing zero-
coupon bonds, such as those described in event 2? What journal entry would
be required to record the payment of these bonds? If financial statements are
prepared each December 31, in which year would the bonds have been
included in current liabilities?

3. (c) Make the journal entry to record the bond issue described in event 3. Note
that the bonds were issued on the same day, yet one was issued at a
premium and the other at a discount. What are some of the reasons that this
may have happened?

4. (d) What are the benefits to Eurotec in having perpetual bonds as described
in event 4? Suppose that in the current year, the bonds are not redeemed
and the interest rate is adjusted to 6% from 7.5%. Make all necessary journal
entries to record the renewal of the bonds and the change in rate.

ACCOUNTING, ANALYSIS, AND PRINCIPLES

The following information is taken from the 2015 annual report of Bugant, Inc.
Bugant's fiscal year ends December 31 of each year.
Additional information concerning 2016 is as follows.

1. Sales were 2,922, all for cash.

2. Purchases were 2,000, all paid in cash.

3. Salaries were 700, all paid in cash.

4. Plant and equipment was originally purchased for 2,000 and is depreciated
on a straight-line basis over a 25-year life with no residual value.

5. Ending inventory was 1,900.

6. Cash dividends of 100 were declared and paid by Bugant.

7. Ignore taxes.

8. The market rate of interest on bonds of similar risk was 16% during all of
2016.

9. Interest on the bonds is paid semiannually each June 30 and December 31.

Accounting
Prepare an income statement for Bugant, Inc. for the year ending December 31,
2016, and a statement of financial position at December 31, 2016. Assume
semiannual compounding.

Analysis

Use common ratios for analysis of long-term debt to assess Bugant's long-run
solvency. Has Bugant's solvency changed much from 2015 to 2016? Bugant's net
income in 2015 was 550 and interest expense was 169.39.

Principles

Recently, the FASB and the IASB allowed companies the option of recognizing in
their financial statements the fair values of their long-term debt. That is, companies
have the option to change the statement of financial position value of their long-
term debt to the debt's fair (or market) value and report the change in statement of
financial position value as a gain or loss in income. In terms of the qualitative
characteristics of accounting information (Chapter 2), briefly describe the potential
trade-off(s) involved in reporting long-term debt at its fair value.

IFRS BRIDGE TO THE PROFESSION

PROFESSIONAL RESEARCH

Wie Company has been operating for just 2 years, producing specialty golf
equipment for women golfers. To date, the company has been able to finance its
successful operations with investments from its principal owner, Michelle Wie, and
cash flows from operations. However, current expansion plans will require some
borrowing to expand the company's production line.

As part of the expansion plan, Wie is contemplating a borrowing on a note payable

or issuance of bonds. In the past, the company has had little need for external
borrowing so the management team has a number of questions concerning the
accounting for these new non-current liabilities. They have asked you to conduct
some research on this topic.

Instructions

Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/)

(you may register for free eIFRS access at this site). When you have accessed the
documents, you can use the search tool in your Internet browser to respond to the
following questions. (Provide paragraph citations.)

1. (a) With respect to a decision of issuing notes or bonds, management is

aware of certain costs (e.g., printing, marketing, and selling) associated with
a bond issue. How will these costs affect Wie's reported earnings in the year
of issue and while the bonds are outstanding?
 2. (b) If all goes well with the plant expansion, the financial performance of Wie
Company could dramatically improve. As a result, Wie's market rate of
interest (which is currently around 12%) could decline. This raises the
possibility of retiring or exchanging the debt, in order to get a lower
borrowing rate. How would such a debt extinguishment be accounted for?

PROFESSIONAL SIMULATION

In this simulation, you are asked to address questions related to the accounting for
non-current liabilities. Prepare responses to all parts.
1
It is generally the case that the stated rate of interest on bonds is set in rather
precise decimals (such as 10.875 percent). Companies usually attempt to align the
stated rate as closely as possible with the market or effective rate at the time of
issue.
2
The carrying value is the face amount minus any unamortized discount or plus
any unamortized premium. The term carrying value is synonymous with book value.
3
The issuance of bonds involves engraving and printing costs, legal and accounting
fees, commissions, promotion costs, and other similar charges. These costs should
be recorded as a reduction to the issue amount of the bond payable and then
amortized into expense over the life of the bond, through an adjustment to the
effective-interest rate. [2] For example, if the face value of the bond is 100,000
and issue costs are 1,000, then the bond payable (net of the bond issue costs) is
recorded at 99,000. Thus, the effective-interest rate will be higher, based on the
reduced carrying value.
4
Because companies pay interest semiannually, the interest rate used is 5% (10%
). The number of periods is 10 (5 years 2).
5
The issuer may call some bonds at a stated price after a certain date. This call
feature gives the issuing corporation the opportunity to reduce its bonded
indebtedness or take advantage of lower interest rates. Whether callable or not, a
company must amortize any premium or discount over the bond's life to maturity
because early redemption (call of the bond) is not a certainty.
6
Determination of the price of a bond between interest payment dates generally
requires use of a financial calculator because the time value of money tables shown
in this textbook do not have factors for all compounding periods. For homework
purposes, the price of a bond sold between interest dates will be provided.
7
Although we use the term note throughout this discussion, the basic principles
and methodology apply equally to other long-term debt instruments.
8
$327 = $1,000(PVF8, i)

.327 = 15% (in Table 6-2 locate .32690).

9
Points, in mortgage financing, are analogous to the original issue discount of bonds.
10
Some companies have attempted to extinguish debt through an in-substance
defeasance. In-substance defeasance is an arrangement whereby a company
provides for the future repayment of a long-term debt issue by placing purchased
securities in an irrevocable trust. The company pledges the principal and interest of
the securities in the trust to pay off the principal and interest of its own debt
securities as they mature. However, it is not legally released from its primary
obligation for the debt that is still outstanding. In some cases, debtholders are not
even aware of the transaction and continue to look to the company for repayment.
This practice is not considered an extinguishment of debt, and therefore the
company does not record a gain or loss. [4]
11
The issuer of callable bonds must generally exercise the call on an interest date.
Therefore, the amortization of any discount or premium will be up to date, and there
will be no accrued interest. However, early extinguishments through purchases of
bonds in the open market are more likely to be on other than an interest date. If the
purchase is not made on an interest date, the discount or premium must be
amortized, and the interest payable must be accrued from the last interest date to
the date of purchase.
12
Likewise, the creditor must determine the excess of the receivable over the fair
value of those same assets or equity interests transferred. The creditor normally
charges the excess (loss) against Allowance for Doubtful Accounts. Creditor
accounting for these transactions is addressed in Chapter 7.
13
An exception to the general rule is when the modification of terms is not
substantial. A substantial modification is defined as one in which the discounted
cash flows under the terms of the new debt (using the historical effective-interest
rate) differ by at least 10 percent of the carrying value of the original debt. If a
modification is not substantial, the difference (gain) is deferred and amortized over
the remaining life of the debt at the (historical) effective-interest rate. [5] In the
case of a non-substantial modification, in essence, the new loan is a continuation of
the old loan. Therefore, the debtor should record interest at the historical effective-
interest rate.
14
Throughout the textbook, we use the label statement of financial position rather
than balance sheet in referring to the financial statement that reports assets,
liabilities, and equity. We use off-balance-sheet in the present context because of its
common usage in financial markets.
15
The IASB has issued consolidation guidance that looks beyond equity ownership as
the primary criterion for determining whether an off-balance-sheet entity (and its
assets and liabilities) should be on-balance-sheet (i.e., consolidated). Specifically,
an investor controls an investee when it is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those
returns through its power over the investee. Thus, the principle of control sets out
the following three elements of control: (1) power over the investee; (2) exposure,
or rights, to variable returns from involvement with the investee; and (3) the ability
to use power over the investee to affect the amount of the investor's returns. In
general, the control principle is applied in circumstances when voting rights are not
the dominant factor in deciding who controls the investee, such as when any voting
rights relate to administrative tasks only and the relevant activities are directed by
means of contractual arrangements. [9] The details of consolidation accounting
procedures are beyond the scope of this textbook and are usually addressed in an
advanced accounting course.
16
It is unlikely that the IASB will be able to stop all types of off-balance-sheet
transactions. Financial engineering is the Holy Grail of securities markets.
Developing new financial instruments and arrangements to sell and market to
customers is not only profitable but also adds to the prestige of the investment
firms that create them. Thus, new financial products will continue to appear that will
test the ability of the IASB to develop appropriate accounting standards for them