s15 ch14 l-term laibilities(1).ppt

Bonds PayableBonds Payable Long-Term Notes Long-Term Notes PayablePayable

Reporting and Reporting and Analyzing Analyzing Long-Term DebtLong-Term Debt

Issuing bondsIssuing bonds

Types and ratingsTypes and ratings

ValuationValuation

Effective-interest Effective-interest methodmethod

Costs of issuingCosts of issuing

ExtinguishmentExtinguishment

Notes issued at face Notes issued at face valuevalue

Notes not issued at Notes not issued at face valueface value

Special situationsSpecial situations

Mortgage notes Mortgage notes payablepayable

Presentation and Presentation and analysisanalysis

Chapter 14: Long-term liabilitiesconsists 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.

Learning Objectives:

Learning Objective :

Bonds PayableBonds Payable

Issuing bondsIssuing bonds

Types and ratingsTypes and ratings

ValuationValuation

Effective-interest methodEffective-interest method

Costs of issuingCosts of issuing

ExtinguishmentExtinguishment

Represents a promise to pay:

(1) sum of money at designated maturity date

+

(2) periodic interest at a specified rate on the maturity

amount (face value). Interest payments usually made

semiannually.

Paper certificate, typically a $1,000 or a $5,000 face

value. Price of bonds stated at 100s.

Bonds Payable= Bond indenture

The Process of Bond Issuance

Underwriters are usually investment banks

The issuing company may sell the bonds directly to a large institution without the aid of an underwriter ( private placement).The issuing company may sell the bonds directly to a large institution without the aid of an underwriter ( private placement).

Types of Bonds: On the basis of

Bond Ratings (Source: BestVest Investments, Ltd)

Moody's S & P Meaning

Aaa AAABest quality, with the smallest amount of risk. Issuers are extremely stable and dependable.

Aa AAHigh quality, with a slightly higher degree of long-term risk.

A AHigh to medium quality, with many strong attributes but with some risk exposure to changing economic conditions.

Baa BBBMedium quality, currently adequate but with significant risk possible over the long term.

Bond Ratings (contd.)Ba BB

Some speculative element, with moderate security but not well safeguarded for the long haul.

B BAble to pay now but with a significant risk of default in the future.

Caa CCC Poor quality with a clear danger of default.

Ca CC High speculative nature, often in or near default.

C CLowest rated, poor prospects of payment going forward but may be current in payments.

-- D In default.

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 investment community values a bond at the present

value of its expected future cash flows, which consist of

(1) interest and (2) principal.

Valuation of Bonds – Discount and Premium

Selling price of a bond issue is set by the

supply and demand of buyers and sellers,

relative risk,

market conditions, and

state of the economy.

Interest Rates

Stated, coupon, or nominal rate =

The interest rate written in the terms of the bond indenture.

Market rate, discount rate, effective rate or yield rate =

rate that provides an acceptable return on an investment

commensurate with the issuer’s risk characteristics.

Rate of interest actually earned by the bondholders.


Interest Rates

Stated, coupon, or nominal rate =

The interest rate written in the terms of the bond indenture.

Market rate, discount rate, effective rate or yield rate =

rate that provides an acceptable return on an investment

commensurate with the issuer’s risk characteristics.

Rate of interest actually earned by the bondholders.


Between the time the company sets the 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.

Bonds Sold AtMarket Interest

6%

8%

10%

Premium

Face Value

Discount

Assume Stated Rate of 8%Assume Stated Rate of 8%


Discount on bonds payable is a liability valuation account,

that reduces the face amount of the related liability (contra-

account).

Classification of Discount and Premium

Balance Sheet (in thousands)

Assets

Cash 40,000$ I nventories 95,000 Plant assets, net 280,000

Total assets 415,000$

Liabilities and Equity

Accounts payable 80,000$ Bonds payable 140,000 Disount on bonds payable (15,000) Common stock, $1 par 150,000 Retained earnings 60,000

Total liabilities and equity 415,000$

Premium on bonds payable

is a liability valuation account,

that adds to the face amount of

the related liability (adjunct

account).


How do you calculate the amount of interest that is actually paid to the bondholder each period?

(Stated rate x Face Value of the bond)

How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds?

(Market rate x Carrying Value of the bond)


1- Use Market Rate of interest ( Discount rate)

2- Computation of selling price:

- PV of maturity value, plus

- PV of interest payments

3- Semi-annual interest paying bonds:

- Require doubling the periods

- Halving the interest rate

Calculating the Selling Price of a Bond


15

Accounting for Bonds Payable –Discount and Premium This discount or premium would be amortized over the

life of the bond.

Amortization methods:1. Straight-Line: the Discount or premium would be amortized equally over the life of the bond.

2. Effective Interest Method Interest Expense = Carrying value of Bond at the

beginning of the period effective rate

16

Accounting for Bonds Payable APB Opinion 21 requires the use of the effective

interest method for the amortization of premium or discount when two amortization methods generate significant different result.

However, the effective interest rate is usually changing from period to period during the life of a bond. As a result, the book value of bonds, very often, does

not equal the present value of bonds.

Produces a periodic interest expense

equal to a constant percentage of

the carrying value of the bonds.

Illustration 14-3

Effective-Interest Method

Valuation of Bonds

Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2014, with a stated interest rate of 8%. Interest paid annually on Dec. 31. Calculate the issue price of the bonds, market interest rate of 8%.

Principal $100,000 x 0.79383 = 79,383$ I nterest 8,000 x 2.57710 = 20,617

Present value 100,000 Face value 100,000

Discount 0$

Market Rate 8% Market Rate 8% (PV for 3 periods at 8%)(PV for 3 periods at 8%)

Solution on notes Solution on notes pagepage

Bonds Issued at Par

Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, a stated interest rate of 8%, and market rate of 8%.

Journal entries?Cash I nterest Carrying

Date Paid Expense Amount

1/ 1/ 11 100,000$

12/ 31/ 11 8,000$ 8,000$ 100,000

12/ 31/ 12 8,000 8,000 100,000

12/ 31/ 13 8,000 8,000 100,000

Bonds Issued at Par

Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 10%.



Discount (4,973)$



Bonds Issued at a Discount


8% 10%Cash I nterest Discount Carrying

Date Paid Expense Amortized Amount

1/ 1/ 11 95,027$

12/ 31/ 11 8,000$ 9,503$ 1,503$ 96,530

12/ 31/ 12 8,000 9,653 1,653 98,183

12/ 31/ 13 8,000 9,817 1,817 100,000 **

* * roundingrounding

Amortize Discount via

Effective Interest method

Illustration: Stated rate = 8%. Market rate = 10%.

1/1/11 Cash 95,027

Discount on bonds payable 4,973

Bonds payable 100,000

12/31/11 Interest expense 9,503


Cash 8,000

Journal entries for 2011:






Cash 8,000

Total discount:

100,000-95,027= 4,973

4,973 / 3= 1,658 per period


Straight-line method

Illustration: Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 6%.



Premium 5,346$



Bonds Issued at a Premium


8% 6%Cash I nterest Premium Carrying


1/ 1/ 11 105,346$

12/ 31/ 11 8,000$ 6,321$ 1,679$ 103,667

12/ 31/ 12 8,000 6,220 1,780 101,887

12/ 31/ 13 8,000 6,113 1,887 100,000

Unamortized bond issue costs are treated as a deferred charge and amortized

over the life of the debt.

Amortize Premium via




1/1/11 Cash 105,346

Premium on bonds payable 5,346




Cash 8,000



Total Premium: 105,346 – 100,000=5,346

5,346/3=1,782




Cash 8,000


Straight Line method

1/1: Interest payment date ($600)The first payment starts on 7/1 of the issuing year1/1: Interest payment date ($600)The first payment starts on 7/1 of the issuing year

7/1: Interest payment date ($600)7/1: Interest payment date ($600)

3/1: Date of Issue.Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue. ( Pay $200)

3/1: Date of Issue.Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue. ( Pay $200)

On the next semiannual interest payment date, purchasers will receive the full six months’ interest payment

On the next semiannual interest payment date, purchasers will receive the full six months’ interest payment

Bonds Issued between Interest DatesBonds Issued between Interest Dates

Consider: Prorate “Interest” and “Discount” or “Premium”.

Illustration: On March 1, 2010, KC Corporation issues 10-year

bonds, dated January 1, 2010, with a par value of $800,000. These

bonds have an annual interest rate of 6 percent, payable

semiannually on January 1 and July 1. Prepare the journal entry to

record the bond issuance at par plus accrued interest.

Cash 808,000

Bonds Payable

800,000

Bond Interest Expense

8,000

($800,000 x .06 x 2/12) = $8,000

Bonds Issued at Par between Interest Dates – ( Use the Straight-line method to count for Interest)Bonds Issued at Par between Interest Dates – ( Use the Straight-line method to count for Interest)

Illustration: On July 1, 2010, four months after the

date of purchase, KC pays the purchaser six months’ interest.

KC makes the following entry on July 1, 2010.

Bond Interest Expense 24,000

Cash

24,000($800,000 x .06 x 6/12) = $24,000 Bond Interest Expense

Debit / Dr. Credit / Cr.

$24,000 $8,000

$16,000$16,000

Bonds Issued at Par between Interest Dates – (Straight-line method)Bonds Issued at Par between Interest Dates – (Straight-line method)

Debt issued between Interest Payment Dates at a DiscountDebt issued between Interest Payment Dates at a Discount

Present value of the bond at 1/1/2015 based on yield of 10% for a term of 2 years. The stated interest rate is 8%.

The interest is paid semiannually. The Face value of the bond is $200,000. The bond was issued on March 1, 2015.

How much should be the issue price?

P.V. of the principal 200,000(given) x .8227 = 164,540

P.V. of Interest 8,000(given) x 3.5460 = 28,368

P.V. on 1/1/2015 $192,908

Debt issued between Interest Payment Dates at a Discount

6 Months Ending

Interest Expense

CashDiscount

AmortizedB.V

1/1/2015 - - - 192,908 7/1/2015 9,645* 8,000 1,645** 194,553

From the 1/1~3/1/2015:• 192,908 x 0.05 = 9,645• Prorated amortization: 9,645 - 8,000 =1,645 1,645*2/6= 548 in which $548 was for the period of 1/1 - 3/1/2015

Debt issued between Interest Payment Dates at A Discount

The P.V. of the bonds on 3/1/2015 =>

(PV0 + Discount Amortized for 2 months) =>192,908x 0.05 (9,645) – 8,000 = $1,645.

PV on 3/1/2015= $192,908 + 1,645 x 2/6= 192,908 + 548= 193,456

Accrued interest from 1/1~ 3/1/2015: = 200,000 x 4% x 2/6=2,667

Debt issued between Interest Payment Dates at A Discount

Therefore, the issue price on 3/1/2015 =>193,456 + 2,667 = $196,123 (including the 2-month accrued interest)

Cash 196,123

Dis. On B/P 6,544**

B/P 200,000

Interest Expense 2,667

** (200,000 - 193,456) or {(200,000 - 192,908) – 548}

Debt issued between Interest Payment Dates at A Discount or A Premium6 Months

EndingInterest

ExpenseCash

Discount Amortize

dB.V

1/1/2015 - - - 192,908 7/1/2015 9,645* 8,000 1,645** 194,55312/31/2015 9,728 8,000 1,728 196,281 7/1/2015 9,814 8,000 1,814 198,09512/31/2015 9,905 8,000 1,905 200,000

Debt issued between Interest Payment Dates at A Discount or A Premium7/1/2015 Interest Expense 9,097

Discount on B/P*1,097

Cash 8,000

* 1,645-548=1,097

12/31/2015 Interest Expense 9,728 Cash8,000

Discount on B/P1,728

Extinguishment before Maturity Date

Reacquisition price > Net carrying amount = Loss

Net carrying amount > Reacquisition price = Gain

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.

Extinguishment of Debt

Illustration: Three year 8% bonds of $100,000 issued on Jan. 1, 2011, are recalled at 105 on Dec. 31, 2012. Expenses of recall are $2,000. Market interest on issue date was 10%.



1/ 1/ 11 95,027$

12/ 31/ 11 8,000$ 9,503$ 1,503$ 96,530

12/ 31/ 12 8,000 9,653 1,653 98,183

Account Balances at Dec. 31, 2012:

Bonds payable =

$98,183

Discount on bonds payable ($4,973–1,503-1,653) =

1,817


Illustration: Three year 8% bonds of $100,000 issued on Jan. 1, 2011, are recalled at 105 on Dec. 31, 2012. Expenses of recall are $2,000. Market interest on issue date was 8%.

Journal entry at Dec. 31, 2012:


Loss on extinguishment 8,817

Cash 107,000


Reacquisition price = $105,000 + 2,000 = $107,000


Unamortized bond issue costs are treated as a deferred

charge and amortized over the life of the debt.

Valuation of Bonds

Cost of Issuing Bonds

Illustration: Microchip Corporation sold $20,000,000 of 10-year

debenture bonds for $20,795,000 on January 1, 2014 (also the

date of the bonds). Costs of issuing the bonds were $245,000.

Microchip records the issuance of the bonds and amortization of

the bond issue costs as follows.

Jan. 1,

2014

Cost of Issuing Bonds

Cash 20,550,000

Unamortized Bond Issue Costs 245,000

Premium on Bonds Payable 795,000

Bonds Payable 20,000,000

Illustration: Microchip Corporation sold $20,000,000 of 10-year

debenture bonds for $20,795,000 on January 1, 2014 (also the

date of the bonds). Costs of issuing the bonds were $245,000.

Dec. 1,

2014

Bond Issue Expense 24,500

Unamortized Bond Issue Costs 24,500

Illustration: On January 1, 2007, General Bell Corp. issued at 97

bonds with a par value of $800,000, due in 20 years. It incurred

bond issue costs totaling $16,000. Eight years after the issue date,

General Bell calls the entire issue at 101 and cancels it. General

Bell computes the loss on redemption (extinguishment).Illustration 14-10



Bonds Payable 800,000

Loss on Redemption of Bonds 32,000

Discount on Bonds Payable

14,400

Unamortized Bond Issue Costs

9,600

Cash

808,000

General Bell records the reacquisition and cancellation of the

bonds as follows:

Learning Objective :

Long-Term Notes PayableLong-Term Notes Payable

Notes issued at face valueNotes issued at face value

Notes not issued at face valueNotes not issued at face value

Special situationsSpecial situations

Mortgage notes payableMortgage notes payable

Long-Term Notes Payable

1. Notes issued at face value

2. Notes NOT issued at face value Zero-interest-bearing notes:

It measures the note’s present value by the cash received. The implicit interest rate is the rate that equals the cash received with the amounts to be paid in the future.

Interest bearing notes

BE14-13: Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company on January 1, 2011, and received cash of $47,663. The implicit interest rate is 12%. Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest.



1/ 1/ 11 47,663$

12/ 31/ 11 0 5,720$ 5,720$ 53,383

12/ 31/ 12 0 6,406 6,406 59,788

12/ 31/ 13 0 7,175 7,175 66,963

12/ 31/ 14 0 8,037 8,037 75,000

Zero-Interest-Bearing Notes

(a) Cash 47,663

Discount on notes payable 27,337

Notes payable 75,000

(b) Interest expense 5,720

Discount on notes payable 5,720($47,663 x 12%)

BE14-13: Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company on January 1, 2011, and received cash of $47,663. The implicit interest rate is 12%. Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest.

Zero-Interest-Bearing Notes

BE14-14: McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on Jan. 1, 2011, and received a computer that normally sells for $31,495. The note requires annual interest payments each Dec. 31. The market rate of interest is 12%. Prepare McCormick’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 interest.



1/1/11 31,495$

12/31/11 2,000$ 3,779$ 1,779$ 33,274

12/31/12 2,000 3,993 1,993 35,267

12/31/13 2,000 4,232 2,232 37,499

12/31/14 2,000 4,501 2,501 40,000

Interest-Bearing Notes

(a) Computer 31,495


Notes payable40,000

(b) Interest expense 3,779

Cash2,000




1/1/11 31,495$

12/31/11 2,000$ 3,779$ 1,779$ 33,274

12/31/12 2,000 3,993 1,993 35,267

Interest-Bearing Notes

Notes Issued for Property, Goods, and Services

When exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless:

(1) No interest rate is stated, or

(2) The stated interest rate is unreasonable, or

(3) The face amount is materially different from the current cash price for the same or similar items or from the market value of the debt instrument.

Special Notes Payable Situations

Choice of Interest Rates

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 company must impute an interest rate.

The choice of imputed interest rate is affected by:

prevailing rates for similar instruments

factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.


The process of interest rate approximation is called “ Imputation”.The process of interest rate approximation is called “ Imputation”.


Illustration: On December 31, 2014, 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, 2019, 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 14-15

Illustration 14-16


Wunderlich records issuance of the note on Dec. 31, 2014, in

payment for the architectural services as follows.

Building (or Construction in Process) 418,239


Notes Payable

550,000


Illustration 14-17

Payment of first year’s interest and amortization of the discount.


Discount on Notes Payable 22,459

Cash 11,000

LO 6

Presentation of Long-Term Debt

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.

Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

Presentation and Analysis of Long-Term Debt

Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Total debt

Total assets

Debt to total assets

=

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

1.1.


Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Income before income taxes and interest expense

Interest expense

Times interest earned =

Indicates the company’s ability to meet interest payments as they come due.

2.2.


The Fair Value Option for Bonds –SFAS No. 159

The book value is computed by “ historical effective interest rate” at date of issue.

The present value (fair value) of bonds is computed by the current effective interest rate.

SFAS 159 allows companies to have the option to report the fair value of the bond on the balance sheet.

59

The Fair Value Option – SFAS No. 159

The difference between the fair value of bonds and the book value is calculated at the end of each period .

This difference is reported as unrealized losses (i.e., fair value > book value) or unrealized gains (i.e., fair value < book value) in the

income statement.

60

SFAS 159 (contd.) Fair value option is an irrevocable decision:

This reporting method can only be adopted at the issuance (origination) of a bond (loan).

Companies can choose the fair value option for one, a few or all of their financial liabilities.

Pension and lease liabilities are excluded from the fair value option.

61

14-62

Non-current liabilities are recorded at fair value, with unrealized

holding gains or losses reported as part of net income.

Fair Value Measurement

Illustrations: Edmonds Company has issued $500,000 of 6 percent

bonds at face value on May 1, 2012. Edmonds chooses the fair

value option for these bonds. At December 31, 2012, the value of

the bonds is now $480,000 because interest rates in the market

have increased to 8 percent.

Bonds Payable 20,000

Unrealized Holding Gain or Loss—Income

20,000

The Fair Value Option

Usual Progression in Troubled-Debt Situations

A troubled-debt restructuring involves one of two basic types of transactions:

1. Settlement of debt at less than its carrying amount.

2. Continuation of debt with a modification of terms.

A troubled debt restructurings occurs when a creditor for economic or legal reasons related to the debtor’s financial difficulties grants a

concession to the debtor that it would not otherwise consider.

A troubled debt restructurings occurs when a creditor for economic or legal reasons related to the debtor’s financial difficulties grants a

concession to the debtor that it would not otherwise consider.

1. Settlement of Debt1. Settlement of Debt

Can involve either a

transfer of noncash assets (real estate, receivables, or other

assets) or

the issuance of the debtor’s stock.

Creditor should account for the noncash assets or equity interest

received at their fair value.

14-65

Illustration : American City Bank loaned $20,000,000 to Union

Mortgage Company. Union Mortgage cannot meet its loan obligations.

American City Bank agrees to accept from Union 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 Union Mortgage.

American City Bank (creditor) records this transaction as follows.

Land 16,000,000

Allowance for Doubtful Accounts 4,000,000

Note Receivable from Union Mortgage

20,000,000

1. Settlement of Debt (Transfer of Assets):

14-66

Illustration : The bank records the real estate at fair value. Further, it

makes a charge to the Allowance

for Doubtful Accounts to reflect the bad debt write-off.

Union Mortgage (debtor) records this transaction as follows.

Note Payable to American City Bank 20,000,000

Loss on Disposal of Land 5,000,000

Land

21,000,000

Gain on Restructuring of Debt

4,000,000

1. Settlement of Debt (Transfer of Assets):

14-67

Illustration: American City Bank agrees to accept from Union Mortgage

320,000 shares of common stock ($10 par) that has a fair value of

$16,000,000, in full settlement of the $20,000,000 loan obligation.

American City Bank (creditor) records this transaction as follows.

Investment 16,000,000


Note Receivable from Union Mortgage

20,000,000

1. Settlement of Debt (Granting an Equity Interest):

14-68

Illustration: It records the stock as an investment at the fair value at

the date of restructure.

Union Mortgage (debtor) records this transaction as follows.

Note Payable to American City Bank 20,000,000

Common Stock

3,200,000

Additional Paid-in Capital

12,800,000

Gain on Restructuring of Debt

4,000,000

1. Settlement of Debt (Granting an Equity Interest):

2. Modification of Terms2. Modification of Terms

A debtor’s serious short-run cash flow problems will lead it to

request one or a combination of the following modifications:

1. Reduction of the stated interest rate.

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

3. Reduction of the face amount of the debt.

4. Reduction or deferral of any accrued interest.

On December 31, 2013, Morgan National Bank enters into a debt restructuring

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:

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

2. Extending the maturity date from December 31, 2013, to December 31,

2017 ( 4 more years) ; and

3. Reducing the interest rate from 12% to 8% (Stated interest rate).

No Gain for debtor:Pre-restructuring carrying value ( $10,500,000) < after restructuring of $11,880,000*

*11,880,000= $9,000,000 ( new principal) +$2,880,000 (interest: 9,000,000*8%*4)

(Example 1—No Gain for Debtor):

New effective interest rate

11,880,000-10,500,000=1,380,000

Notes Payable 356,056


Cash

720,000

Dec. 31, 2014

(Example 1—No Gain for Debtor):Schedule Showing Reduction of Carrying Amount of NoteDebtor’s Calculations:

Debtor must compute a new effective interest rate ( indicates by i in the formula)

to record interest expense in the future period.

The rate necessary to discount the total future cash flows ( $11,880,000) to a present value equal to the remaining balance ($10,500,000) $10,500,000 = 1/(1+i)4 * $9,000,000 + {1-(1/(1+i) 4 )/i }*$720,000

Calculator: N=4 PV=10,500,000 PMT=-720,000 FV= -9,000,000 1/YR= 3.466 ( New effective interest)

Notes Payable 9,000,000

Cash

9,000,000

Maturity Maturity date: date:

Dec. 31, Dec. 31, 20172017

(Example 1—No Gain for Debtor): Debtor’s Computation

Morgan National Bank (creditor)

Morgan National Bank records bad debt expense as follows

Bad Debt Expense 2,593,428


Market Interest rate: 12%

(Example 1—No Gain for Debtor): Creditor’s Computation

Creditor Calculations

Illustration 14A-4Illustration 14A-4

In subsequent periods, Morgan National Bank reports interest

revenue based on the historical effective rate.

Cash 720,000

Allowance for Doubtful Accounts 228,789

Interest Revenue 948,789

Dec. 31, 2010Dec. 31, 2010

b. 7,906,572*12%=948,789c. 948,789-720,000=228,789d. 28 adjustment to compensate for rounding



The creditor makes a similar entry (except for different amounts

debited to Allowance for Doubtful Accounts and credited to Interest

Revenue) each year until maturity.

At maturity, the company makes the following entry.

Cash 9,000,000


Notes receivable 10,500,000

Dec. 10, 2017Dec. 10, 2017


Illustration: Assume the facts in the previous example except that Morgan

National Bank reduces the principal to $7,000,000 (and extends the maturity

date to December 31, 2017 and reduces the interest from 12% to 8%).

• The total future cash flow is now $9,240,000 ($7,000,000 of principal plus

$2,240,000 of interest) < $10,500,000 ( difference is $1,260,000)

Under these circumstances, Resorts Development (debtor) reduces the carrying

amount of its payable $1,260,000 and records a gain of $1,260,000.

(Example 2—Gain for Debtor):

Note Payable carrying value after restructuring: 10,500,000-1,260,000=9,240,000 ( Equal the sum of the undiscounted cash flows) ---Imputed interest rate is 0 %.

Debtor AccountingDebtor Accounting

Morgan National Bank (creditor) debits its Bad Debt Expense for $4,350,444.

(Example 2—Gain for Debtor):

Creditor AccountingCreditor Accounting


Morgan National reports interest revenue the same as the previous

example—

(Example 2— Gain for Debtor):

Accounting for periodic interest payments and final principal payment.

(Example 2— Gain for Debtor):

Recognize no interest expense 7,000,000*8%

s15 ch14 l-term laibilities(1).ppt

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