Intermediate Accounting-37C Long Term Debt Page 1

Transcription

1 Intermediate Accounting-37C Long Term Debt Page 1 LONG-TERM DEBT I. Review of Key Concepts and Terms A. Characteristics of Long term Debt 1. Debt represents the creditors' equity (creditors ownership interest) in the company. There are two basic types of long term debt: a. Bonds: Bonds are financing instruments offered by a borrowing company to a lender (investor); 1. Bond issues are generally for very large sums of money (more money than a single investor would lend); 2. Issuance of bonds (often denominated in $1,000 amounts) allows several lenders (investors) to share the risk and return on large scale borrowing be determining how many bonds to purchase; 3. Bonds are usually traded in the financial markets and allow investors to buy and sell at will; 4. Commercial bonds are often issued in denominations of $1,000 dollars with a stated interest rate (the nominal rate) and maturity date printed on the certificate; (governmental bonds (T-bills) are issued in denominations of $5,000, $10,000 or more, but our emphasis will be on commercial bonds) b. Notes: Notes are written promises to pay a sum of money to a lender at a specific time; 1. Notes may result from business situations involving goods and receivables or as a result of borrowing 2. Notes are issued for relatively small sums of money that one lender can handle in terms of risk and required capital outlay. 3. Notes are usually held by the issuer or traded (discounted) in a specialized or restricted manner. The market for notes is such that they are not traded on a daily basis to average investors. 4. Notes are issued in the amount borrowed rather than a pre-established amount. Note: For purposes of simplifying this discussion, illustrations will be limited to bonds. The distinctions between the nature of bonds and notes are outlined above. In most cases, the accounting issues are the same and the same procedures are applied. Recall that bond issues are usually reserved for very large financing activities, and as a result will often have unique characteristics (such as sinking funds and independent trustees) that are not applicable to notes. In most cases such differences will be readily apparent. Where these differences result in different accounting procedures, such differences will be pointed out in the subsequent discussion. 2. Debt instruments differ from equity securities (stocks and other owners equity securities) in three important ways: a. debt instruments are legal contracts to pay specific amounts; b. debt instruments must be paid at a specific point in time (maturity date) and c. debt instruments must pay interest on the amounts owed 1. the amount of interest is usually stated on the face of the instrument; 2. some notes (bonds will always have a state rate) may not have a stated interest rate; if the interest is not stated or is not representative of the market rate of interest for debt instruments of similar quality, the interest rate must be imputed. 3. These differences afford creditors (bondholders or note holders) specific advantageous rights and protection with regard to: a. Return of principle: 1. Bonds and notes represent formal contracts between a borrower and a lender that require the borrower to repay the face amount of the debt at the maturity date. If the value of debt securities declines below face value, the lenders are legally entitled to recover the face value, and may pursue those rights in a court of law. 2. Equity securities normally contain no maturity date represent investments by owners as opposed to creditors. If the value of equity securities decline, the owners have no legal recourse. b. Yield on Investment (to lender) or cost of capital (to borrower): The yield on an investment (or cost of capital if borrowing) can be defined as the annual return paid by the investment divided by the full cost of the investment. 1. Yield on investments in debt instruments is based on the ratio of interest receipts to total cost. Interest is a legal liability of the borrowing company and must be paid. Failure to pay interest has recourse in a court of law. 2. Yield on investments in equity instruments is based on the ratio of dividends to the total cost of

2 Intermediate Accounting-37C Long Term Debt Page 2 the securities. Dividends are distributions of profits to the stockholders (owners) that are made at the discretion of the board of directors. They are not guaranteed and do not become a legal liability until declared. Stockholders have no legal recourse if dividends are not declared. Note: The yield of any security must also take into account the gain or loss realized upon sale. 4. That portion of long term debt that is due in the current year is normally listed in the current liability section of the balance sheet; the non current portion of debt is the amount that is not expected to be repaid in the current year or the operating cycle of the business, whichever is longer. B. Advantages and Disadvantages of Financing Operations with Long Term Debt 1. Advantages: (to the issuer) a. Financing through debt may have a lower cost: because of legal protection described above, debt financing usually has less risk and consequently may be available at a lower cost to the borrower; b. No dilution of voting rights: Investors in debt securities are not owners and therefore have no voting rights; c. Tax advantages: Interest payments are expenses of the company and deductible for tax purposes as compared to dividend distributions which are distributions of equity and are not tax deductible to the corporation; d. Always available: Companies with no track record often can not obtain financing in the equity securities market; most companies with sound prospects of earnings can borrow through debt financing through bonds (to the public) or notes (from a bank or similar institution). e. Ability to increase earnings per share by "Trading on Equity": A corporation can increase its earnings per share by issuing bonds only if they can earn more money with the borrowed funds then they have to pay out in bond interest. The ability to generate income from borrowing is called "trading on equity". Trading on Equity Example: --MDC Corporation has 1,000 shares of common stock issued and outstanding. --Projected net income from normal operations is $20,000; --Earnings per share would be $20 ($20,000/1,000 shares outstanding) --MDC is considering an investment with an estimated yield of 15 percent. This yield would be in addition to normal projected income --The capital needed for this investment is $100, MDC is short on cash and does not want to dilute ownership by issuing stock If MDC decides to issue $100,000 of 10 percent bonds (on January 1, 20x1; interest paid annually) and generates the projected additional net income $15,000 in addition to $20,000 from their other projects. After paying the interest to the bondholders MDC had net earnings of $25,000; Earnings from normal operations was $20,000 Earnings from investment: 15,000 Less: Bond interest cost: (10,000) Change in net income: 5,000 Note that MDC was able to increase EPS to $25/sh (($20, ,000)/1,000 shares) = $25/sh 2. Disadvantages: (to issuer) a. Interest payments are legal liabilities: failure to meet interest payments can result in legal recourse from creditors b. Specified maturity date: the bonds (usually a very large sum of money) must be repaid at a specific point in time, thus forcing the issuer to set aside funds for their retirement that could otherwise be used for operations. C. Bond Terminology and Characteristics 1. Bond Indenture: a contractual agreement between borrower (issuer) and lender (investor) listing the terms and conditions of the bond issue; 2. Trustee: An independent party named in the bond indenture to protect the rights of the issuer and the investors with respect to the bond indenture;

3 Intermediate Accounting-37C Long Term Debt Page 3 3. Bond Sinking Fund: A long term fund established to retire long term bonds. Sinking funds are generally associated with term bonds. Since term bonds become due all at once (e.g. 10 years) the bondholders need to know that the cash will be available in the future to repay the principal of the bond indenture. On the other hand, serial bonds (a bond issue where the entire bond indenture is retired in installments) mature on an annual basis so a large lump sum at one time is not needed. All that is needed is an amount to redeem that portion of the bond indenture that becomes due in the current year. 4. Sweeteners: Characteristics of bonds that make them more attractive (competitive) to investors. "Sweeteners" are designed to enable the issuer to offer the bonds at a lower interest cost in return for giving up other features such as making the bonds redeemable or convertible at the option of the holder. 5. Debenture Bonds: Debenture bonds are unsecured bonds; they are secured only by the promise of the corporation and are not secured by any specific assets. To protect the unsecured bondholders, debenture agreements usually require that limitations be placed on the corporations payment of dividends (through a restriction of retained earnings), restrictions on borrowing and restrictions on the reacquisition of its own stock. Debenture bonds may be senior or subordinated. In general, debenture bondholders are ranked with general creditors in the event of a defalcation (senior debenture bondholders are paid prior to subordinated debenture bondholders) the exact terms must be specified in the bond indenture. 6. Mortgage bonds: Mortgage bonds are secured by specific assets of the corporation (in addition to the promise of the corporation). If the corporation is unable to pay the bondholders the interest or repay the principal at maturity, the pledged assets can be used to satisfy the amounts due the bondholders. If the pledged assets are insufficient to meet the obligation to the mortgage bondholders, the mortgage bondholders are ranked with the general creditors in their attempt to obtain further returns on their investments. 7. Registered and Coupon Bonds: Registered bonds are "registered" with the corporation or a specified "transfer agent". Interest payments are made to the owners of record; when the bonds are traded the corporation or transfer agent must be notified. Coupon bonds are unregistered; they contain "coupons" that are clipped and presented to the corporation for payment (usually through banks). Coupon bonds have been legislated out of existence by changes in the tax code. Corporations issuing bonds after December 31, 2082 cannot deduct the related interest expense unless the bonds are registered. 8. Zero Coupon (Deep Discount) Bonds: Zero Coupon bonds bear low or no stated interest. Consequently little or no interest is paid until maturity. Yield is based on the difference between purchase price and maturity value and the time period to maturity. 9. Callable and Redeemable Bonds: Callable Bonds may be called in at the option of the corporation at a specified price. Redeemable bonds are redeemable at the option of the borrower at a specified price. The redeemable feature is considered a "sweetener". 10. Convertible Bonds: Convertible bonds may be converted into equity securities (normally common stock) at the option of the holder at a specified exchange ratio. The convertible feature is considered a "sweetener". 11. Revenue and General Obligation Bonds: Revenue bonds are generally issued by governmental agencies and the principle and interest are payable from specified revenue sources only; General obligation bonds are also issued by governmental agencies but are not secured by specific funding sources. General obligation bonds are secured by the "full faith and credit" of the issuing agency. D. Accounting for Bonds Payable at the Date of Issuance 1. The issuance of bonds payable is recorded as follows: Cash (cash received for bonds)... xxxxx Discount on bonds payable (cash for bonds less accrd int exp is < face value of bonds)....xxxxx Premium on bonds payable (cash for bonds less accrd int exp > face value)... xxxxx Interest expense (amount of interest accrued on bonds since last interest payment)... xxxxx Bonds payable (always recorded at face value)... xxxxx

4 Intermediate Accounting-37C Long Term Debt Page 4 2. Illustrative examples of recording the issuance of bonds: a. For the purpose of illustrating the various aspects of recording the issuance of bonds, assume the following facts: --DBD, Inc is preparing to issue ten thousand $1,000 bonds; --The stated rate of interest on the bonds will be 6% and the interest will be paid semiannually on 6/30 and 12/31. Example 1: (Recording the bond at date of issue; sold on interest date; no premium or discount) --DBD issues the bonds on 6/30/x1 for $10,000,000. Cash (cash received for bonds; 10,000 x $1,000)... 10,000,000 Bonds payable (always recorded at face value)... 10,000,000 Example 2: (Recording the bond at date of issue; sold on interest date; at premium or discount) --DBD issues the bonds on 6/30/x1 for $10,250,000. Cash (cash received for bonds;)... 10,250,000 Premium on bonds payable (cash for bonds less accrued int exp > face value) ,000 Bonds payable (always recorded at face value)... 10,000,000 Example 3: (Recording the bond at date of issue; sold between interest dates; no premium or discount) --DBD issues the bonds on 9/30/x1 for $10,150,000. Cash (cash received for bonds)... 10,150,000 Interest expense ($10,000,000 x.06 x 3/12) ,000 Bonds payable (always recorded at face value)... 10,000,000 Example 4: (Recording the bond at date of issue; sold between interest dates; at premium or discount) --DBD issues the bonds on 9/30/x1 for $10,050,000. Cash (cash received for bonds)... 10,050,000 Disc. on B/P(cash for bonds less accrued int exp is < face value of bonds) ,000 Interest expense ($10,000,000 x.06 x 3/12) ,000 Bonds payable (always recorded at face value)... 10,000,000 Summary of General Rules for Recording Bonds Liabilities General Rules:1. Bonds payable are always recorded at face value. 2. Record cash at the full amount received. 3. If bonds payable are sold between the interest dates, accrue the amount of interest expense (or interest payable); the amount of cash allocable to the bonds is total cash received less amounts paid for accrued interest. 4. Premiums or discounts on bonds payable must be recorded separately. 5. Premiums or discounts on bonds payable must be amortized over the life of the bond using the effective interest method (unless the difference between the amortization using the effective interest method and the straight line method are considered immaterial) Note: When we discuss investments in bonds, we do not have to record the premium or discount separately. In the case of investments, the investment is recorded at full cost. Refer to handout 27A for complete details. E. Accounting for the Amortization of Premiums and Discounts on Bonds Payable 1. Bond interest rates are fixed for the life of the bond. If that stated bond rate is greater than the market rate of interest, investors will pay more for the bond; conversely if the stated rate is lower than the market rate, investors will pay less than the face value of the bond. This concept is illustrated below: a. bond rate of interest is higher than the market rate of interest: -- Assume that a bond has a stated interest rate of 10 percent and the market rate of interest is 6 percent. The face amount of the bond is $1,000 and interest is paid annually. Therefore the bond is paying interest

5 Intermediate Accounting-37C Long Term Debt Page 5 of $100 per year (face amount of the bond $1,000 x.10, the bond interest rate). Since the market rate of interest is 6 percent, investing $1,000 in another investment opportunity would only yield $60 per year ($1,000 investment x.06, the market interest rate). Therefore, investors would be willing to pay more than the face value of the bond in order to earn $1,000. How much more they would be willing to pay is determined using present value calculations. When bonds are sold for more than their face value they are said to be sold at a PREMIUM. b. bond rate of interest is lower than the market rate of interest: --Assume that a bond is paying an interest rate of 6 percent and the market rate of interest is 10 percent. The face amount of the bond is $1,000 and interest is paid annually. Therefore the bond is paying interest of $60 per year (face amount of the bond $1,000 x.06, the bond interest rate). Since the market rate of interest is 10 percent, investing $1,000 in another investment opportunity would yield $100 per year ($1,000 investment x.10, the market interest rate). Therefore, investors would not be willing to pay the face value of the bond ($1,000) in order to only earn $60, a six percent return in this example. How much less the investor would be willing to pay to purchase the bond is determined using a present value calculation. When bonds are sold for less than their face value they are said to be sold at a DISCOUNT. Determining the sales price of a bond: The price that investors will pay for a bond is the sum of the present value of the maturity value of the bond and the present value of the annuity (interest payments) to be received over the life of the bond discounted at the investors cost of capital. This concept is illustrated below: LYC Inc. has determined that it has an excess of $1,000,000 cash on hand that will not be needed for operational activities in the short term. The company desires to invest these funds in some marketable security that will yield at least 10 percent per annum at an acceptable level of risk. LYC Inc. is considering an investment in DBD Inc. bonds. DBD Inc. bonds are denominated in $1,000 certificates with a stated interest rate of 6% per annum. Interest is paid semiannually at 6/30 and 12/31. The bonds mature on 12/31/x4 and LYC Inc. anticipates holding them until maturity. If LYC Inc purchases the bonds on 1/1/x0, how much can LYC Inc. pay for these bonds and still its yield target of 10%? Solution: PV of $1,000,000 in 5 years at 10% (n=10, i=5) * ( x $1,000,000) $ 613,913 PV of an ordinary annuity of 10 payments at 10% per annum (n=10, i=5) ,652 ($30,000 x ) Amount LYC Inc. can pay and still earn minimum required yield... $ 845,565 * Note: n and i must correspond to the annuity period 2. APB-21 requires that bond premiums and discounts must be amortized over the life of the bond so that at the maturity date, premiums/discounts will have been reduced to a zero balance. This amortization process is accomplished by adjusting the bond interest expense by the amortization of the premium or discount over the life of the bond payable. The reason for doing this is to allocate the premium/discount over all periods of the bonds life. 3. APB-21 further requires that the amortization of bond premiums/discounts be accomplished by utilizing the "effective interest method". The effective interest method insures that the interest expense is the same in each period. Straight line amortization has the effect of charging less interest in the initial years of the bond, and more in latter years. The straight line amortization method is only allowable for external reporting purposes if there is no material difference between the two methods (very unlikely). The following example illustrates and contrasts the straight line method and the effective interest method:

6 Intermediate Accounting-37C Long Term Debt Page 6 F. Comparison of Straight Line and Effective Interest Methods of Amortizing Bond Premiums or Discounts LYC, Inc Effective Interest Method of Amortization 5.00% Issue Payment Effective (Premium) Carrying Number Payment Interest Amort Discount Value 0 154, , ,000 42,278 12, , , ,000 42,892 12, , , ,000 43,537 13, , , ,000 44,214 14, , , ,000 44,924 14,924 86, , ,000 45,671 15,671 70, , ,000 46,454 16,454 54, , ,000 47,277 17,277 37, , ,000 48,141 18,141 19, , ,000 49,048 19, ,000,000 LYC, Inc Straight Line Method of Amortization Issue Payment (Premium) Carrying Number Payment Amort Discount Value 0 154, , ,000 15, , , ,000 15, , , ,000 15, , , ,000 15,443 92, , ,000 15,443 77, , ,000 15,443 61, , ,000 15,443 46, , ,000 15,443 30, , ,000 15,443 15, , ,000 15, ,000,000

7 Intermediate Accounting-37C Long Term Debt Page 7 Note: It is important to recognize that the interest charges using the "Effective Interest Method" are at a constant percentage of the carrying value of the bond. For example the period 1 interest charge of $42,278 is 5% of the carrying value of $845,565 and the period 10 interest charge of $49,048 is 5% of the carrying value of $980,952. On the other hand, the interest charges using the "straight line" method of interest amortization vary from period to period. For example the rate of interest in period 1 is % ($45,443/$845,565) and for period 10 is % ($45,443/$984,557). The "Effective Interest Method" is superior to the straight line method because it adjusts interest expense at the same rate in each period. G. Accounting for the Retirement of Bonds Payable 1. Retirement of bonds at maturity date: a. When bonds are retired at the maturity date the accounting is straightforward: Bonds payable... xxxxx Cash (face value of bonds) If a sinking fund had been established the entry would be: Bonds payable... xxxxx Bond Sinking fund... xxxxx xxxxx b. When bonds are retired prematurely and between interest dates other accounting issues are created. 1. A corporation may decided to retire unmatured bonds by buying them back from the bondholders only if there is a provision for such action in the bond indenture or, in the absence of such a provision, the bondholders agree. A retirement of bonds prior to maturity is called an early extinguishment of debt and gains or losses resulting from the early retirement are treated as an extraordinary items on the income statement if they are both infrequent and unusual for the business (SFAS 145). Recall that extraordinary items are reported as line items, net of tax effects after income from continuing operations. 2. As in an ordinary retirement, the Bonds Payable Account will be taken off the books at face value. However, before the entries to record the bond retirement are made, the final interest payment and applicable amortization must be recorded. In addition, because the bonds are being retired prematurely, any unamortized premium or discount must be eliminated. The difference between the sum of the face value of the bonds and the unamortized premium or discount and the amount paid to retire the bonds would be an extraordinary gain or loss. 3. The journal entries to record a premature retirement (Early extinguishment of debt) of bonds payable is illustrated below. --Assume that the DBD Inc. bonds purchased by LYC Inc are prematurely retired at the end of period 7 by paying $985,000 and that DBD Inc. used the effective interest method of amortization. DBD Inc. would make the following journal entries: Bonds payable (always taken of the books at face value)... 1,000,000 Interest payable... 30,000 Loss on Redemption (Retirement) of Bonds.. 9,465** Cash.. 985,000 Discount on Bonds Payable (per table period 7). 54,465 Unamortized bond issuance costs (if any) -0- Gain on Redemption (Retirement) of bonds -0-** **EI if both infrequent and unusual II. Notes Payable: Like Bonds, Notes are formal written promise to pay a fixed amount at a certain date. Unlike bonds, notes do not have to state an interest rate. Notes without a stated interest rate are referred to as Non- Interest Bearing Notes or Zero Interest Notes.

8 Intermediate Accounting-37C Long Term Debt Page 8 A. Non-Interest (Zero Interest) Notes: Technically there is no such thing as a zero interest note because if no Interest rate is stated (and the note is issued for cash) the note will be recorded at it s present value (the amount of cash received) and the difference between it s present value and the face value of the note will be amortized over the life of the note using the effective interest method at the Implicit Interest Rate. 1. Implicit Interest Rate: The implicit interest rate is the rate that equates the cash received to the future value (face value) of the note. a. Example 1: Assume that LYC issues a three year, non-interest bearing note (that makes 2 payments per year) with a face value of $10,000 and receives $ in return. 1. What is the interest rate on the note? 8% PVnote/FVnote=PVIF 7,983.32/ = Record the note in years 1, 2 and 3 From PV sum table n=3, find PVIF under 8% Year 1 Cash 7, Cash Received Discount on NP 2, Notes Payable 10,000 Always at Face Value Interest Exp Disc on NP Note that there is no payment value in a zero Interest Note because the payment (Discount) was taken by the lender up front. The face value of the note will be paid at maturity Year 2 Interest Exp Discount on NP Year 3 Interest Exp Discount on NP NP 10,000 Cash 10,000 Amortization Schedule Time Discount Carrying FV of Period PMT Interest Amort. Value Note 0 2, , , (635.07) 1, , , (685.87) , , (740.74) , , B. Interest Bearing Notes (Issued for Cash): 1. Unless there is compelling evidence, the state rate of the note is assumed to be the market rate, and there is no discount on the note. In the event that there is compelling evidence that the stated rate is less than the market rate, the difference between the PV of the note computed at the market rate and the amount received is the discount, which is amortized using the effective interest method. a. Example 2: Interest Bearing Note Issued below Market Rate Assume that the note issued by LYC in example had a stated rate of 8% and that the market rate was 10%. Solution: cash issued for the note = PV of sum (Face Value) = PV 10,000 n=3, i=10 = PV of annuity (interest revenue) = PVA 800 n=3, i=10 = Carrying FV of Time Period Payment Interest Amortization Discount Value Note , , (150.26) , , (165.29) , , (181.82) , , PV of note Discount $7, $1, $9, $ Year 1 Year 2 Year 3 Cash Interest Exp Interest Exp Disc on NP Disc on NP Disc on NP NP 10,000 Cash Cash Interest Exp NP 10,000 Disc on NP Cash 10,000 Cash

9 Intermediate Accounting-37C Long Term Debt Page 9 C. Notes Issued for Property or Goods and Services: The stated rate of interest is presumed fair unless the stated rate discounts the note to an amount materially different from the value of the property, goods or services. 1. Valuation: Valuation is based on the PV of the note or the FMV of the goods or services (which ever is most readily apparent) Note: In general the stated interest rate on the note is presumed to be fair unless: a. The borrower and lender are not operating at arms-length (they are not independent parties b. There is no state rate c. The state rate is unreasonable for the given circumstances d. The face value of the note is materially different from the current cash sales price of similar items or the current FMV of the note. D. Troubled Debt Restructuring: SFAS-15 a troubled debt restructuring occurs when a creditor for economic or legal reasons related to a debtor s financial difficulties grants a concession to the debtor that it would not otherwise consider. Troubled debt restructurings include, but are not limited to: 1. Modification of terms: See Table below for differences in accounting be Debtor/Creditor 2. Issuance or other granting of equity interest (same accounting for Debtor/Creditor) 3. Transfers of receivables (same accounting for Debtor/Creditor) General rules for Accounting For Troubled Debt Restructuring a. The carrying value of the liability is compared to undiscounted future cash flows (principal + Interest) 1. Modification of Terms Debtor: a. if CV of Liability is <= Undiscounted future cash flow 1. no gain is recognized 2. CV of liability is not reduced 3, interest expense is recognized in future periods using an appropriate imputed interest rate b. if CV of Liability is > Undiscounted future cash flow 1. The debtor recognizes a gain 2. The CV of the liability is reduced 3. Interest Exp is not recognized in future periods Creditor a. Creditor records the adjusted asset at FMV, eliminates the CV of the old asset and recognizes a loss 1. The investment in the restructured loan is computed by discounting the total future cash flows under the terms of the new agreement. 2. Loss = PV of future cash flows - CV of Receivable (old)

10 Intermediate Accounting-37C Long Term Debt Page 10 E. MORTGAGE NOTES PAYABLE A mortgage note is a note secured by real property. Mortgage notes are normally paid in equal installments a portion of which is allocated to interest expense and the balance is allocated to principle. In general montage notes are amortized over the life of the note (usually 15 to 30 years). In some notes it is possible to have a negative amortization. Negative amortization results when the periodic payment is insufficient to cover the periodic interest expense and as a result, the principle balance owed in increased rather than decreased. The following table illustrates a mortgage amortization schedule of a $42,000, 2 year loan at 9% interest Pmt Period (n=period) Monthly Payment (A) Monthly Interest (B) Mortgage Reduction (C) Mortgage Balance (D) (9 percent) (A-B) (D n-1 -C) , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) , , (1,918.76) ,

11 Intermediate Accounting-37C Long Term Debt Page 11 III. Pensions: A pension is a contractual arrangement between a company and its employees under which the company agrees to provide retirement benefits to covered employees. Contributions to the plan by the company and/or the employees are made to a pension fund managed by a trustee. The cost of pension plans is one of the most important factors in modern labor/management relations and greatly effects the competitiveness of American business enterprises. Accounting for pension plans is one of the most complex issues in accounting. The following discussion provides only the basic concepts. A. Types of Pension Plans 1. Defined Contribution Plans: the employer is required to contribute an annual amount determined by contractual arrangement with employees. Retirement benefits will depend upon the amount that the accumulated pension fund balance can support at the time of retirement. 2. Defined Benefit Plans: the employer is required to contribute an amount that will support defined benefits to the employee upon retirement based upon the employees present salary status and benefits. The contribution must take into account a fixed amount of future benefits based upon uncertain future developments such as the actuarial life span of the covered employees, the return the fund can make and an estimates of promotions and pay raises that employees will accumulate prior to retirement. The employer is only required to fund the plan on a current termination basis, i.e. contributions are made on the basis that an employee will retire at the same pay grade and with the same benefit package. If an employee gets promoted and retirement benefits increase, the fund must play catch up to accumulate sufficient benefits to fund the newly increased retirement benefits. B. Accounting for Pension Plans 1. Defined Contribution Plans: Accounting for pension costs under defined contribution plans is simple Pension expense (based on predefined contribution agreement)... Cash (or Pension Liability)... xxxx xxxx 2. Defined Benefit Plans: Accounting for defined benefit contribution plans is one of the most complex issues in accounting and is addressed in this text in concept only. Fortunately, in concept, the issues are not too complex. Pension Expense (normal cost + amortization of past service cost)... Cash (normal cost funded currently + past service cost funding). Pension Liability (Shortfall of current funding v. actuarial determined pension expense)... Raiding Corporate Pension Plans xxxx xxxx xxxx Note: If cash contributions exceeded the actuarially determined expense an asset would be created. This asset is called Prepaid Pension Expense or Deferred Pension Expense. In recent years, companies with these accounts have been takeover targets by larger firms. More recently, CALPERS, the California Personnel Employee Retirement System had 1 Billion dollars taken out of the Deferred Pension Expense account to help meet the budget shortfall in California. Pension Expense (normal cost + amortization of past service cost)... Deferred Pension Expense (Excess of funding > Expense... Cash (normal cost funded currently + past service cost funding)... xxxx xxxx xxxx

12 Intermediate Accounting-37C Long Term Debt Page 12 Short Answer: 1. bonds frequently require the establishment of a to insure sufficient funds for their retirement. 2. Bondholders have specific advantageous rights. These advantageous rights of bondholders are: a. b. 3. When bonds are issued at a premium the company's bond interest expense on their income statement is than the actual interest paid. 4. The two disadvantages of a bond issue over the issue of share capital are: a. b. 5. Because bonds are purchased at the market interest (as compared to the stated bond interest rate) either a or on bond liability is created when the bonds are issued. 6. bonds may be exchanged for shares of the corporation. 7. In order to protect the owners of subordinated debenture bonds, the bondholders may require restriction be placed on. 8. A bond discount or premium may be amortized by using either the of method. 9. If $100,000 12% bonds are issued for $99,500 on the interest date, they are issued at a. 10. If $100,000 12% bonds are issued for $101,500 two months after the interest date, they are issued at a. True or False Questions 1. When a company issues bonds, the shareholders maintain their management control. 2. The face value of the bonds is the amount that the company must receive for the bonds. 3. The bond discount should be written off as soon as possible. 4. Investors will pay a premium for bonds when the market interest rate is below the bond contract interest rate. 5. A sinking fund is set up to guarantee the bondholders that funds will be available to redeem the bonds at maturity. 6. Bond discounts and premiums amortized by the effective interest method results in the same interest expense as the straight-line method. 7. The market interest rate can differ from the bond contract interest rate. 8. Convertible bonds may be cashed any time the bondholder wishes. 9. Bond interest is deductible from the corporation's taxable income.

13 Intermediate Accounting-37C Long Term Debt Page 13 Problem 1 (Bonds issued between interest payment dates with straight-line discount or premium amortization, and a comparison between issuing the bonds as opposed to preferred stock). On November 1, 20X1, the Kline Corp. issued $1,000,000-worth of 9-percent, 20-year bonds. Interest is payable semi-annually on May 1 and November 1. Kline uses the straight-line method of amortization of premiums and discounts. Required: Situation one: The bonds were issued at Make the necessary journal entries to record the issue of all the bonds on November 1, 20X1; --the adjusting entry at December 31, 20X1; and --the entry to record the payment of the bond interest on May 1, 20X2; Situation two: The bonds were issued at Make the necessary journal entries to record the issue of all the bonds on November 1, 20X1; --the adjusting entry at December 31, 20X1; and --the entry to record the payment of the bond interest on May 1, 20X2; Situation three: The bonds can be issued at par, or 40,000 shares of $1.50 preferred stock at $25 per share can be issued. The company's proposed income is $160, What would the earnings per share to the common shareholders be under each alternative? (There are 10,000 shares of common shares outstanding.) --Assume a tax rate of 40% Problem 2The next problem shows the accounting for bonds issued or sold between interest payment dates, including the accrued interest and how a premature retirement of the bonds requires the writing-off of any discount or premium relating to the retired bond. (Issue and retirement of bonds between interest payment dates and premature retirement) Cadis Inc. received authorization on April 1, 20X1 to issue $1,000,000-worth of 12-percent, 5-year bonds. Interest is payable semi-annually on April 1 and October 1. The corporation has a December 31 year-end. Cadis Inc. uses the straight-line method of amortization of discounts and premiums on bonds. Required: Prepare the journal entries to record the following transactions: 20X1 Jul 2Issued $500,000 bonds at 96.58, plus accrued interest. Oct 1Paid the semi-annual interest and amortized the bond discount. Dec 31Recorded the year-end adjusting entries. 20X2 Apr 1Paid the semi-annual interest and amortized the bond discount. May 1Prematurely retired $300,000 of the bonds for $310,000, plus interest to date.

14 Intermediate Accounting-37C Long Term Debt Page 14 Problem 3The setting-up of a bond sinking fund, the recording of the bond interest payments, the recording of the annual sinking fund income, the retirement of the bonds, and the closing of the sinking fund are examined in this problem. On the date of authorization, January 1, 20X1, the Lambert Corp. issued 10-percent, 3-year sinking fund bonds with a face value of $600,000 at 102, with interest payable semi-annually on June 30, and December 31. The sinking fund indenture requires an annual contribution at the end of each of the 3 years to provide for the retirement of the bonds at maturity. As an added protection, the terms of the bond indenture require that retained earnings be restricted in an annual amount equal to the total addition to the sinking fund. The Lambert Corp. is to make the deposit of $184, each year to the Lane Trust Co., which has been named trustee of the sinking fund. Lane Trust guaranteed the Lambert Corp. a return of 8-percent annually, which will be credited to the Sinking Fund account each December 31. Required: Prepare all the journal entries from the issue to the retirement of the bonds, including any year-end adjustments that may be required.

15 Intermediate Accounting-37C Long Term Debt Page 15 Problem 4The next problem involves the issuance of the bonds at two different times, both at the beginning of an interest payment period. Lambert uses straight line amortization. The Union Transit Co. Ltd. decided to finance externally through a sale of bonds to an investment firm. Union Transit Co. operates on a fiscal year ending October 31. You are provided with the following information: 20X1 Jul 1Issued $100,000 of the $200, percent, 10-year bonds dated July 2, 20X1, interest payable semi-annually on June 30 and December 31. The bonds were issued for $107,200. Oct 31Year-end adjusting entries are prepared. Paid semi-annual bond interest. Dec 31Paid semi-annual bond interest 20X2 Jan 2Issued remaining bonds at Jun 30Paid semi-annual bond interest Oct 31Year-end adjusting entries are prepared Required: 1.Prepare all journal entries necessary on each of the above dates. Union Transit Co. Ltd. has an October 31 year-end and uses straight line amortization. 2. Calculate the amount of interest paid in 20X2: $ 3. Calculate the total interest expense incurred through the year-ended October 31, 20X2: $ Problem 5The next problem shows how the effective interest method is used for amortization of bond discounts or premiums and shows that the amount amortized each period will vary depending on the carrying value of the bond issue. -- On August 1, 20X1, Western Sports Inc. issued $2,000,000 worth of 8.4-percent, 10-year bonds dated August 1, 20X1, with interest payable on February 1 and August 1. --The bonds were all issued at a price to yield 8 percent to the bondholders who purchased them. Western Sports Inc. uses the effective interest method of amortizing bond discounts and premiums, and has a December 31 year-end. Required: 1. Prepare a schedule detailing the computation of the sales price of the bonds. 2. Prepare an interest amortization table using the effective interest method. 3. Prepare the journal entries (rounding calculations to the nearest dollar) to record the issue of the bonds on August 1, 20X1; the December 31, 20X1 year-end adjusting entry; and the interest payments on February 1, 20X2 and August 1, 20X2 for the bond issue.

16 Intermediate Accounting-37C Long Term Debt Page 16 SOLUTIONS Key Concept Comprehension 1. term / sinking fund 2. a. To receive the face value of the bond at a specified date. b. To receive periodic interest payments at the specified times and at the stated interest rate. 3. lower 4. a. The company may not earn enough money to pay the bond interest. b. Bondholders must receive the principal at maturity and the company may not have the funds to redeem the bonds at that time. 5. discounts / premiums 6. Convertible 7. restriction of retained earnings, borrowing, and reacquisition of stock 8. straight-line / effective interest 9. discount 10. discount True or False Questions 1. T 2. F The face value of the bonds is the amount that must be paid to the bondholders at maturity, regardless of whether the bonds were issued at a premium or discount. 3. F The bond discount should be amortized over the term of the bonds. 4. T 5. T 6. F The interest expense varies each interest payment period under the effective interest method, but the interest expense is the same for each interest payment period under the straight-line method. 7. T 8. F Convertible bonds allow the bondholders to become shareholders. 9. T SOLUTIONS TO PROBLEMS Problem 1 Situation One 1: 20X1 Nov 1 Cash (1,000,000 x 1.045)...1,045,000 Premium on Bonds (plug)... 45,000 Bonds Payable (always at face value)... 1,000,000 To record the issue of $1,000,000 9% 20 yr bonds at Dec 31 Bond Interest Expense (plug)... 14,625 Premium on Bonds ($45,000/240 x Bond Interest Payable (1,000,000 x.09 x 2/12)... 15,000 To record bond interest accrual and amortization of the bond premium. $45,000/240 months = $187.50/month x 2 mos = $375 20X2 May 1 Bond Interest Expense (plug)... 29,250 Premium on Bonds ($45,000/240 x 4) Bond Interest Payable (eliminate interest accrued 12/31/x1)... 15,000 Cash (1,000,000 x.09 x 6/12)... 45,000 To record semi-annual bond interest payment and amortization of the bond premium. $ 1,000,000 x 9% x 1/2 = $45,000 $1,125 x4/6= $750 $45,000 x 4/6 = $30,000 - $750 = $29,250

17 Intermediate Accounting-37C Long Term Debt Page 17 Situation Two: 20X1 Nov 1 Cash (1,000,000 x.94) ,000 Discount on Bonds (plug)... 60,000 Bonds Payable (always at face value)... 1,000,000 To record the issue of $1,000,000 9% 20 yr bonds at 94. Dec 31 Bond Interest Expense (plug)... 15,500 Discount on Bonds (60,000/240 x 2) Bond Interest Payable (1,000,000 x.09 x 2/12)... 15,000 To record bond interest accrual and amortization of the bond discount. 20X2 May 1 Bond Interest Expense (plug)... 31,000 Bond Interest Payable (eliminate interest accrued 12/31/x1)...15,000 Discount on Bonds (60,000/240 x 4)... 1,000 Cash (1,000,000 x.09 x 6/12)... 45,000 To record semi-annual bond interest payment and amortization of the bond discount. $ 1,000,000 x 9% x 6/12 = $45,000 $ 1,500 x 4/6 = $ 1,000 $45,000 x 4/6 = $30,000 + $ 1,000 = $31,000 Situation Three: Alternative One Alternative Two Issue bonds at par Issue 40,000 shares of $1.50 $25 Projected Net Income... $ 160,000 $ 160,000 Bond Interest Expense ($1,000,000 x.09)... (90,000) -0- Net Income Before Tax... $ 70,000 $ 160,000 Income Tax Expense (40%)... 28,000 64,000 Net Income After Tax... $ 42,000 $ 96,000 Preferred Dividends (40,000 x $1.50) ,000 Net Income Available to Common Stock... $ 42,000 $ 36,000 EPS (NI avail to C/S /Common Shares outstanding).$ 4.20/share $ 3.60/share SOLUTION TO PROBLEM 2 20X1 Jul 2 Cash ($500,000 x [($500,000 x.12) x 3/12]) ,900 Discount on Bonds (plug)... 17,100 Bond Interest Payable ($500,000 x.12 x 3/12)... 15,000 Bonds Payable (always at face value) ,000 To record the issue of 12% 5-year bonds at 96.58, plus accrued interest. Oct 1 Bond Interest Expense ($15,000 + $900 = $ 15,900 or plug)... 15,900 Bond Interest Payable (eliminate interest accrued 7/2/x1)... 15,000 Discount on Bonds ($17,100/57 months = $300/month x 3 months). 900 Cash ($500,000 x 12% x 6/12)... 30,000 To record semi-annual bond interest payment and amortization of the bond discount. Dec 31 Bond Interest Expense (Int pay + amort of discount for 3 mos)... 15,900 Discount on Bonds Bond ($17,100/57 months = $300/month x 3) Interest Payable ($500,000 x.12 x 3/12)... 15,000 To record semi-annual bond interest amortization of the bond discount.

18 Intermediate Accounting-37C Long Term Debt Page 18 20X2 Apr 1 Bond Interest Expense ($15,000 + $900 or plug)... 15,900 Bond Interest Payable (eliminate interest accrued 12/31/x1)... 15,000 Discount on Bonds ($17,100/57 months = $300/month x 3) Cash ($500,000 x 12% x 6/12)... 30,000 To record semi-annual bond interest payment and amortization of the bond discount. May 1 Bond Interest Expense ($500,000 x.12 x $300/$500 x 1/12)... 3,000 Bonds Payable (always at face value) ,000 Extraordinary Loss on Retirement of Bonds ((cv - cash pd for bond) 15,640 * Discount on bonds payable (14,400 x (300,000/500,000)... 8,640 Cash ,000 Supporting computations entry in problem 2: To record retirement of $300,000 12% 5-yr bonds for $310,000 plus accrued interest to date. * computed as follows: Carrying value: ($300,000 - (14,400 x $300,000/$500,000)... $ 291,360 Cash paid for bond: (Total cash paid less cash paid for accrued interest = $310,000 - $ 3,000). 307,000 $ ( 15,640) Discount on Bonds Payable Beginning Balance: 7/2/x1 17, / 1/x /31/x / Bal Prior to Retirement: 5/1/2 14,400 8,640 5/ 1/x2 Solution Problem 3: 20X1 Jan 1 Cash ($600,000 x 1.02) ,000 Sinking Fund Bonds Payable (always at face value) ,000 Premium on Bonds Payable (plug)... 12,000 To record the issue of $600,000 10% 3-yr sinking fund bonds at par Jun 30 Bond Interest Expense (Int payable - amort of sales premium)... 28,000 Premium on Bonds Payable ($12,000/6)... 2,000 Cash ($600,000 x.10 x 6/12)... 30,000 To record the semi-annual bond interest payment and amortization of the premium on the bonds. Dec 31 Bond Sinking Fund (per bond indenture instructions) , Cash , To record deposit of sinking fund with trustee Dec 31 Retained Earnings , Retained Earnings Reserved for the Sinking Fund , To set up the retained earnings reserves to correspond to the sinking fund agreement. Dec 31 Bond Interest Expense (Int payable - amort of sales premium).. 28,000 Premium on Bonds Payable ($12,000/6)... 2,000 Cash ($600,000 x.10 x 6/12)... 30,000 To record the semi-annual bond interest payment and amortization of the premium on the bonds.

19 Intermediate Accounting-37C Long Term Debt Page 19 20X2 Jun 30 Bond Interest Expense (Int payable - amort of sales premium)... 28,000 Premium on Bonds Payable ($12,000/6)... 2,000 Cash ($600,000 x.10 x 6/12)... 30,000 To record the semi-annual bond interest payment and amortization of the premium on the bonds. Dec 31 Bond Sinking Fund ($184, x.08)... 14, Cash... 14, To record earnings of sinking fund for one year Dec 31 Bond Sinking Fund (per bond indenture instructions) , Cash , To record deposit of sinking fund with trustee Dec 31 Retained Earnings (184, ,785.61) , Retained Earnings Reserved for the Sinking Fund , To set up the retained earnings reserves to correspond to the sinking fund agreement. Dec 31 Bond Interest Expense (Int payable - amort of sales premium) 28,000 Premium on Bonds Payable ($12,000/6)... 2,000 Cash ($600,000 x.10 x 6/12)... 30,000 To record the semi-annual bond interest payment and amortization of the premium on the bonds. 20X3 Jun 30 Bond Interest Expense (Int payable - amort of sales premium) 28,000 Premium on Bonds Payable ($12,000/6)... 2,000 Cash ($600,000 x.10 x 6/12)... 30,000 To record the semi-annual bond interest payment and amortization of the premium on the bonds. Dec 31 Bond Sinking Fund (($199, ,820.11) x.08)... 30, Cash... 30, To record earnings of sinking fund for one year Dec 31 Bond Sinking Fund (per bond indenture instructions) , Cash , To record deposit of sinking fund with trustee Dec 31 Retained Earnings (184, ,754.06) , Retained Earnings Reserved for the Sinking Fund , To set up the retained earnings reserves to correspond to the sinking fund agreement. Dec 31 Bond Interest Expense (Int payable - amort of sales premium)... 28,000 Premium on Bonds Payable ($12,000/6)... 2,000 Cash ($600,000 x.10 x 6/12)... 30,000 To record the semi-annual bond interest payment and amortization of the premium on the bonds. 20X4 Jan 1 Sinking Fund Bonds Payable (always at face value) ,000 Bond Sinking Fund ,000 To record the retirement of the bonds utilizing the sinking fund. Jan 1 Retained Earnings Reserved for Sinking Fund ,000 Retained Earnings ,000 To cancel the retained earnings reserve established for the sinking fund