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Intermediate Chapter 14 Notes

by: Emily Sears

Intermediate Chapter 14 Notes 3310

Marketplace > Auburn University > Accounting > 3310 > Intermediate Chapter 14 Notes
Emily Sears
GPA 3.2

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About this Document

These notes cover Chapter 14 material
Intermediate Accounting I
Dr. Duane Brandon
Class Notes
Intermediate 1, Accounting
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This 14 page Class Notes was uploaded by Emily Sears on Saturday January 30, 2016. The Class Notes belongs to 3310 at Auburn University taught by Dr. Duane Brandon in Spring 2016. Since its upload, it has received 26 views. For similar materials see Intermediate Accounting I in Accounting at Auburn University.


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Date Created: 01/30/16
CHAPTER 14: Financing: Liabilities: Bonds and Long-Term Notes Payable Long-Term Liabilities Long Term Liabilities consists of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer Examples:  Bonds payable  Notes payable  Mortgages payable  Deferred taxes  Certain contingencies  Pension liabilities  Lease liabilities Reasons for Issuance of L-T Liabilities 1. Debt financing may be the only available source of funds 2. Debt financing may have a lower cost 3. Debt financing offers an income tax advantage 4. The voting privilege is not shared 5. Debt financing offers the opportunity for leverage Bonds Payable Terminology Bond- a type of note in which a company agrees to pay the holder the face value at the maturity date and usually to pay interest periodically at a specified rate on the face value BondCertificate- a legal document that specifies details (ex: face value, annual interest rate, maturity date) Bond Indenture- a document (contract) that defines the rights of the bondholders See Exhibit 14.1 for the many different characteristics of bonds The face (or par) value is the amount that the issuer agrees to pay at maturity. Corporate bonds usually have face value of $1,000 each. The stated, face, nominal, coupon, or contract rate is the rate at which the issue of the bond agrees to pay interest each period until maturity. Interest payments usually made semiannually. The yield (effective rate) is the market rate at which the bonds are actually sold. Bond Issuance Selling prices are set by the market – not the issuer! Between the time the company sets the terms and time is 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 investment community values a bond at the present value of its expected future cash flows, which consists of (1) interest and (2) principal …thus, bonds can be issued at Discount: Effective Yield > Stated Rate → Int. Expense > Int. Paid Par: Effective Yield = Stated Rate → Int. Expense = Int. Paid Premium: Effective Yield < Stated Rate → Int. Expense < Int. Paid Entry to record issuance of bonds at authorization date: Discount: Dr. Cash Dr. Discount on Bonds Payable ← contra BP account Cr. Bonds Payable Premium: Dr. Cash Cr. Premium on Bonds Payable ← adjunct BP account Cr. Bonds Payable The book value (carrying value) of the bond issue at any time is the face value plus any unamortized Premium or face value minus any unamortized discount Note, bonds are often issued b/w interest payment dates Amortizing Discounts and Premiums Two methods for amortizing bond discountsand premiums Recall, when a company sells bonds at a discount or premium, it is incurring an effective interest (yield) rate this is more, or less, than the stated rate of interest. Interest expense on the Income Statement must show an amount based on the effective interest rate and the book value of the bonds. 1. Effective interest method- required by GAAP to achieve objectives above 2. Straight-line method- discount/premium amortized to interest expense in equal amounts. This method is only allowed by GAAP if the results are not materially different from effective interest method Bond Examples ABC issues 100 $1,000 bonds on 1/01/2010 with a stated interest rate of 10% and a maturity date of 12/31/2017. Interest is payable semiannually. Note, int. pmts. equal $5,000 each ($100,000 × 10% stated rate × 6/12). Record the issuance of the bonds and the first interest payment under the three scenarios below assuming the Effective Interest Method is applied: Scenario 1 (issued at par): Assume market rate is 10% Scenario 2 (issued at discount): Assume market rate is 12% Scenario 3 (issued at premium): Assume market rate is 8% See ex. On 14-5 and 14-6 for practice Bond Issue Costs Bond issue costs are treated as a deferred charge (reported as an “Other Asset” on the Balance Sheet) and amortized over the life of the debt Amortization is typically based on a straight-line method: Dr. Bond Interest Expense $ ** Cr. DeferredBond Issue Costs $ ** Bonds Retiredat Maturity On the balance sheet issued within one year prior to the maturity date, a company reclassifies the face value (and any related premium or discount) of the bonds from a noncurrent (long-term) to a current liability if it will use current assets to repay the obligation. On the maturity date, after the last interest payment is recorded, any premium or discount is fully amortized. Thus, book value = maturity value Dr. Bonds Payable $ ** Cr. Cash $ ** Bonds Retired Prior toMaturity Call provisions allow a company to recall its debt issue at a prestated % of the face value prior to the maturity date. The call price is generally above the issue price, triggering a loss. Alternatively, a company can purchase its debt on the openmarket, triggering a gain or loss (depending upon the current relationship between the book value and market value of the debt) Whether bonds are recalled, retired, or refunded prior to maturity, any gain or loss is reported as a component of income from continuing operations in the current period Gain vs. Loss Reacquisition price > Net carrying amount = Loss Net carrying amount > Reacquisition price = Gain Note, at time of reacquisition, unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date. Retirement prior tomaturity example Channing Corporation originally issued $100,000 of 12% bonds at 97 on January 1, 2016. The bonds have a 10-year life, pay interest on January 1 and July 1, and are callable at 105 plus accrued interest. The company amortizes the discount by the straight-line method. On June 30, 2021, the company recalls the bonds. Bonds with EquityCharacteristics Bonds may be issued that allow creditors to ultimately become stockholders either by attaching stock warrants (option to purchase a certain amount of common stock at a state price within a certain time period) to the bonds or including a conversion feature (option to exchange the bond for a predetermined amount of the bond issuer’s equity within a certain time period) These “sweeteners” generally result in either a relatively lower interest rate or greater proceeds when compared with bond issues with similar risk but without such rights Stock Warrants- If the warrants are detachable, a portion of the proceeds from selling the bonds must be allocated to the stock warrants. (If non-detachable, then no allocation is allowed) Convertible bonds are recorded solely as debt at time of issuance Two methods for recording the conversion from debt to equity are allowed: 1. Book value method- Record the stock at the book value of the convertible bonds and do not record a gain or loss. This method is the most widely used. 2. Market value method- Record the stock at the market value of the stock or debt, whichever is more reliable, and recognize a gain or loss Long-Term Notes Payable Recognize the L-T Notes Payable concepts parallel L-T Bond Concepts Regardless of how a note is structured legally, the note is recorded at its present value and the effective interest method is used to record the interest (or straight-line if results are not materially different). GAAP provides guidance for cases where the interest is not stated or the interest rate is clearly not appropriate GAAP addresses three major categories of notes: 1. Notes exchanged for cash 2. Notes exchanged for cash and rights or privileges 3. Notes exchanged for property, goods, or services It is presumed that a stipulated interest rate is fair unless:  No interest rate is recorded  Stated interest rate is clearly unreasonable  Face value of the note is materially different from the cash sales price of the property, or services, or from the fair value of the note on the transaction date. In any of these situations, the note receivable is recorded at the fair value of the property, goods, or services or the fair value of the note, whichever is more reliable. If neither of these values is reliable, the note is recorded at its present value by using the borrower’s incremental interest rate (2) N/Pexchanged forcash and rights/privileges L-T notes exchanged for cash may include rights or privileges. These rights or privileges must be considered when accounting for these notes. For example, a company may borrow from a customer on a non-interest bearing basis, with the understanding that the customer has the right to purchase goods from the company at a discounted price. In essence, the customer pre-pays future purchases. 1. Note is recorded at its PV by discounting the maturity value using the incremental interest rate of the borrower 2. Interest expense is recorded over life of note using effective interest method 3. Difference between cash proceeds and PV of note is recorded as unearned revenue. Unearned revenue is recognized over life of contract (per unit basis or straight-line basis) Notes Not responsible for:  Induced conversions (14-23)  Convertible Bonds that Require Recognition of an Equity Component (14-24)  Guarantees (14-32)  Appendices 1 & 2 (14-35 to 14-45)


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