IA IFRS 2nd PDF

CHAPTER
14 Non-Current Liabilities
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the formal procedures associated with 6 Describe the accounting for the extinguishment
issuing long-term debt. of non-current liabilities.
2 Identify various types of bond issues. 7 Describe the accounting for the fair value option.
3 Describe the accounting valuation for bonds at date 8 Explain the reporting of off-balance-sheet financing
of issuance. arrangements.
4 Apply the methods of bond discount and premium 9 Indicate how to present and analyze non-current
amortization. liabilities.
5 Explain the accounting for long-term notes payable.
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.
Current Global Public Debt
$ 52,521,833,443,124,156
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 substan-
tial 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
CONCEPTUAL FOCUS
> See the Underlying Concepts on pages 660
and 676.
30-Year Bond Issuance > Read the Evolving Issue on page 679 for a
$90 discussion of off-balance-sheet reporting.
INTERNATIONAL FOCUS
(in billions)
60
> Read the Global Accounting Insights on
$92 pages 681–682 for a discussion of non-IFRS
30 billion*
financial reporting of liabilities.
0
1995 2000 ’05 ’10
Corporate Investment Grade Yields for issuing these bonds because they provide a substantial
9%
cash infusion at a relatively low interest rate. Hopefully, it
will work out for both the investor and the company in the
6 long run.
Sources: A. Sakoui and N. Bullock, “Companies Choose Bonds for

Cheap Funds,” Financial Times (October 12, 2009); http://www.
3
economist.com/content/global_debt_clock; V. Monga, “Companies
Feast on Cheap Money Market for 30-Year Bonds, Priced at Stark
2.77%†
Lows, Brings Out GE, UPS and Other Once-Shy Issuers,” Wall
0 Street Journal (October 8, 2012); and Josh Noble, “Sinopec Raises
1995 2000 ’05 ’10 €550m from Euro Bond Sale,” Financial Times (October 10, 2013).
†As of Oct. 5. Other yield data are recorded on the last day of each year.
*Year to date.
Sources: Dealogic (bond issuance); Barclays (yields); and Wall Street Journal.
As our opening story indicates, companies may rely on different

PREVIEW OF CHAPTER 14
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.
Non-Current Liabilities
Bonds Payable Long-Term Notes Payable Special Issues
• Issuing bonds • Notes issued at face value • Extinguishments

• Types and ratings of bonds • Notes not issued at face value • Fair value option
• Valuation • Special situations • Off-balance-sheet financing
• Effective-interest method • Mortgage notes payable • Presentation and analysis
653
654 Chapter 14 Non-Current Liabilities
BONDS PAYABLE
Non-current liabilities (sometimes referred to as long-term debt) consist of an
LEARNING OBJECTIVE 1
expected outflow of resources arising from present obligations that are not pay-
Describe the formal procedures
able within a year or the operating cycle of the company, whichever is longer.
associated with issuing long-term
debt. 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 autho-
rized to be issued, interest rate, due date(s), call provisions, property pledged as secu-
rity, sinking fund requirements, working capital and dividend restrictions, and limita-
tions 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 93/8 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 sup-
ply. 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 en-
abling 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 com-
pany, thus taking the risk of selling the bonds for whatever price they can get (firm un-
derwriting). 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).
LEARNING OBJECTIVE 2 Types and Ratings of Bonds

Identify various types of bond
Presented on the next page, we define some of the more common types of bonds
issues.
found in practice.
Bonds Payable 655
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 col-
lateral 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. Seri-
ally 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 market—commodity-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
8½ 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

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

Vodafone Group 5.00 2018/06/04 106.66 4.05 AA
Telecom Italia S.p.A. 5.25 2022/10/02 100.00 5.25 BB1
The companies issuing the bonds are listed in the first the second column is the interest rate paid by the bond as a
column, in this case, two telecommunications companies, percentage of its par value, followed by its maturity date.
Vodafone Group (GBR) and Telecom Italia S.p.A (ITA). In The Vodafone bonds, for example, pay 5 percent and mature
on June 4, 2018. The Telecom Italia bonds pay 5.25 percent, a

Bond Price Changes in 1% Interest 1% Interest
bit higher. The Vodafone bonds have a current yield of 4.05 Response to Interest Rate Rate
percent, based on the price of 106.66 per £1,000. In contrast, Rate Changes Increase Decrease
the Telecom Italia bonds at 100.00 yield 5.25 percent. The Short-term fund (2–5 years) 22.5% 12.5%
final column gives the bond rating. Vodafone, with a rating Intermediate-term fund (5 years) 25% 15%
of AA, is viewed as more creditworthy than Telecom Italia, Long-term fund (10 years) 210% 110%
which explains why Vodafone’s bonds sell at a higher price Source: The Vanguard Group.
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 Another factor that affects bond prices is the call feature,
bond values. Similarly, a decrease in interest rates will lead to which decreases the value of the bond. Investors must be
a rise in bond values. The following data, based on three dif- rewarded for the risk that the issuer will call the bond if inter-
ferent bond funds, demonstrate these relationships between est rates decline, which would force the investor to reinvest
interest rate changes and bond values. at lower rates.
Valuation of Bonds Payable

The issuance and marketing of bonds to the public does not happen overnight.
LEARNING OBJECTIVE 3 It usually takes weeks or even months. First, the issuing company must arrange
Describe the accounting valuation
for underwriters that will help market and sell the bonds. Then, it must obtain
for bonds at date of issuance.
regulatory approval of the bond issue, undergo audits, and issue a prospectus (a
document that describes the features of the bond and related financial informa-
tion). 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 sell-
ers, relative risk, market conditions, and the state of the economy. The investment com-
munity 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 computa-
tion 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 prin-
cipal cash flows.
Bonds Payable 657
ILLUSTRATION 14-1
PV R$100,000 Principal Time Diagram for Bonds
Issued at Par
i = 9%
PV-OA R$9,000 R$9,000 R$9,000 R$9,000 R$9,000 Interest
0 1 2 3 4 5
n=5
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 of the principal:
R$100,000 3 .64993 (Table 6-2) R$ 64,993 Present Value
Present value of the interest payments: Computation of Bond
R$9,000 3 3.88965 (Table 6-4) 35,007 Selling at Par
Present value (selling price) of the bonds R$100,000
By paying R$100,000 (the par value) at the date of issue, investors realize an effec-
tive rate or yield of 9 percent over the five-year term of the bonds. Santos makes the
following entry when it issues the bonds.
January 1, 2015
Cash 100,000
Bonds Payable 100,000
Santos records accrued interest expense of R$9,000 (R$100,000 3 .09) at December 31,
2015 (year-end), as follows.
December 31, 2015
Interest Expense 9,000
Interest Payable 9,000
It records the first interest payment as follows.

January 1, 2016
Cash 9,000
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
or market rate. If bonds sell at a discount, the effective yield exceeds the stated rate.
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.
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 PV R$100,000 Principal
Issued at a Discount
i = 11%
PV-OA R$9,000 R$9,000 R$9,000 R$9,000 R$9,000 Interest
0 1 2 3 4 5
n=5
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 of the principal:

Present Value R$100,000 3 .59345 (Table 6-2) R$59,345.00
Computation of Bond Present value of the interest payments:
Selling at a Discount R$9,000 3 3.69590 (Table 6-4) 33,263.10
Present value (selling price) of the bonds R$92,608.10
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 2 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 inter-
est 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?

H
Yes, some companies issue bonds with maturities that exceed Why do companies issue 100-year bonds? A number of
a person’s lifetime. For example, Électricité de France S.A. investors, such as pension funds and insurance companies,
(FRA) in early 2014 sold 100-year bonds in Europe. The have non-current liabilities. They need long-duration assets
world’s biggest operator of nuclear reactors priced £1.35 bil- to reduce an asset-liability mismatch. While investing in a
lion of notes to yield 6.125 percent. The Paris-based utility is 100-year bond carries interest-rate risk, long-term debt has
the second company to sell century bonds in Europe, follow- an offsetting effect against long-duration assets. Thus, this
ing GDF Suez S.A. (FRA) in March 2011. group of investors has a strong demand for these bonds.
Bonds Payable 659
Other multibillion-dollar companies, such as Walt Disney You may be surprised to learn that 1,000-year bonds also
Company (USA) and The Coca-Cola Company (USA), have exist. A few issuers, such as the Canadian Pacific Corpora-
issued 100-year bonds in the past. Many of these bonds and tion (CAN), have issued such bonds in the past. And, there
debentures contain an option that lets the debt issuer partially have also been instances of bonds issued with no maturity
or fully repay the debt long before the scheduled maturity. For date at all, meaning that the debt issuers continue fulfilling
example, the 100-year bond that Disney issued in 1993 is sup- the coupon payments forever. These types of financial instru-
posed to mature in 2093, but the company can start repaying ments are commonly referred to as perpetuities.
the bonds any time after 30 years (2023).
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 dif-
4 LEARNING OBJECTIVE
ferent 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 Apply the methods of bond discount
and premium amortization.
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.
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- See the Authoritative
interest method (also called present value amortization). Under the effective-interest Literature section
method, companies: [1] (page 684).
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. 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 Interest Expense Bond Interest Paid Bond Discount and
Premium Amortization
Carrying Value Effective- Face Amount Stated Amortization Computation
of Bonds at × Interest – of × Interest = Amount
Beginning of Period Rate Bonds Rate
The effective-interest method produces a periodic interest expense equal to a con-

stant percentage of the carrying value of the bonds.3
2
The carrying value is the face amount minus any unamortized discount or plus any unamor-
tized 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.
Underlying Concepts Bonds Issued at a Discount

To illustrate amortization of a discount under the effective-interest method,
Because bond issue costs do Evermaster Corporation issued €100,000 of 8 percent term bonds on January 1,
not meet the definition of an 2015, due on January 1, 2020, with interest payable each July 1 and January 1.
asset, some argue they should
Because the investors required an effective-interest rate of 10 percent, they paid
be expensed at issuance.
€92,278 for the €100,000 of bonds, creating a €7,722 discount. Evermaster com-
putes the €7,722 discount as follows.4
ILLUSTRATION 14-6 Maturity value of bonds payable €100,000

Computation of Discount Present value of €100,000 due in 5 years at 10%, interest payable
on Bonds Payable semiannually (Table 6-2); FV(PVF10,5%); (€100,000 3 .61391) €61,391
Present value of €4,000 interest payable semiannually for 5 years at
10% annually (Table 6-4); R(PVF-OA10,5%); (€4,000 3 7.72173) 30,887
Proceeds from sale of bonds (92,278)
Discount on bonds payable € 7,722
The five-year amortization schedule appears in Illustration 14-7.
ILLUSTRATION 14-7 SCHEDULE OF BOND DISCOUNT AMORTIZATION

Bond Discount EFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS
Amortization Schedule 5-YEAR, 8% BONDS SOLD TO YIELD 10%
Carrying
Calculator Solution for
Present Value
Cash Interest Discount Amount
of Bonds: Date Paid Expense Amortized of Bonds
Inputs Answer 1/1/15 € 92,278
7/1/15 € 4,000a € 4,614b € 614c 92,892d
N 10 1/1/16 4,000 4,645 645 93,537
7/1/16 4,000 4,677 677 94,214
1/1/17 4,000 4,711 711 94,925
I/YR 5 7/1/17 4,000 4,746 746 95,671
1/1/18 4,000 4,783 783 96,454
7/1/18 4,000 4,823 823 97,277
PV ? 92,278 1/1/19 4,000 4,864 864 98,141
7/1/19 4,000 4,907 907 99,048
1/1/20 4,000 4,952 952 100,000
PMT –4,000 €40,000 €47,722 €7,722
a
€4,000 5 €100,000 3 .08 3 6/12 c
€614 5 €4,614 2 €4,000
FV –100,000 b
€4,614 5 €92,278 3 .10 3 6/12 d
€92,892 5 €92,278 1 €614
Evermaster records the issuance of its bonds at a discount on January 1, 2015, as

follows.
Cash 92,278
It records the first interest payment on July 1, 2015, and amortization of the discount
as follows.
Bonds Payable 614
Cash 4,000
4
Because companies pay interest semiannually, the interest rate used is 5% (10% 3 6/12). The
number of periods is 10 (5 years 3 2).
Bonds Payable 661
Evermaster records the interest expense accrued at December 31, 2015 (year-end),
and amortization of the discount as follows.
Bonds Payable 645
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
Maturity value of bonds payable €100,000 Computation of
Present value of €100,000 due in 5 years at 6%, interest payable
Premium on Bonds
semiannually (Table 6-2); FV(PVF10,3%); (€100,000 3 .74409) €74,409
Present value of €4,000 interest payable semiannually for 5 years
Payable
at 6% annually (Table 6-4); R(PVF-OA10,3%); (€4,000 3 8.53020) 34,121
Proceeds from sale of bonds (108,530)
Premium on bonds payable € 8,530
The five-year amortization schedule appears in Illustration 14-9.
SCHEDULE OF BOND PREMIUM AMORTIZATION

ILLUSTRATION 14-9
EFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS Bond Premium
5-YEAR, 8% BONDS SOLD TO YIELD 6% Amortization Schedule
Carrying
Calculator Solution for
Interest Premium Amount Present Value
Date Cash Paid Expense Amortized of Bonds of Bonds:
1/1/15 €108,530 Inputs Answer
7/1/15 € 4,000a € 3,256b € 744c 107,786d
1/1/16 4,000 3,234 766 107,020 N 10
7/1/16 4,000 3,211 789 106,231
1/1/17 4,000 3,187 813 105,418
7/1/17 4,000 3,162 838 104,580 I/YR 3
1/1/18 4,000 3,137 863 103,717
7/1/18 4,000 3,112 888 102,829
1/1/19 4,000 3,085 915 101,914 PV ? 108,530
7/1/19 4,000 3,057 943 100,971
1/1/20 4,000 3,029 971 100,000
€40,000 €31,470 €8,530 PMT –4,000
a
€4,000 5 €100,000 3 .08 3 6/12 c
€744 5 €4,000 2 €3,256
b
€3,256 5 €108,530 3 .06 3 6/12 d
€107,786 5 €108,530 2 €744
FV –100,000
Evermaster records the issuance of its bonds at a premium on January 1, 2015, as

follows.
Cash 108,530
Evermaster records the first interest payment on July 1, 2015, and amortization of
the premium as follows.
Bonds Payable 744
Cash 4,000
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 state-
ments 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 fi-
nancial reporting dates. However, what happens if Evermaster prepares financial
statements at the end of February 2015? In this case, the company prorates the pre-
mium by the appropriate number of months to arrive at the proper interest expense,
as follows.
ILLUSTRATION 14-10
Computation of Interest Interest accrual (€4,000 3 2/6) €1,333.33
Premium amortized (€744 3 2/6) (248.00)
Expense
Interest expense (Jan.–Feb.) €1,085.33
Evermaster records this accrual as follows.

Interest Expense 1,085.33
Bonds Payable 248.00
Interest Payable 1,333.33
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 amortized (March–June) (€744 3 4/6) €496.00
Premium amortized (July–August) (€766 3 2/6) 255.33
Premium Amortization
Premium amortized (March–August 2015) €751.33
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 semi-
annual 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
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.
Bonds Payable 663
par (€100,000). Evermaster records the issuance of the bonds between interest dates as
follows.
May 1, 2015
Cash 100,000
(To record issuance of bonds at par)
Cash 2,667
Interest Expense (€100,000 3 .08 3 4/12) 2,667
(To record accrued interest; Interest Payable
might be credited instead)
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 inves-
tors six months’ interest, by making the following entry.
Interest Expense
July 1, 2015
5/1/15 2,667a
b
7/1/15 4,000
Cash 4,000
(To record first interest payment) Balance 1,333
a
Accrued interest received.
The Interest Expense account now contains a debit balance of €1,333 (€4,000 2 €2,667), b
Cash paid.
which represents the proper amount of interest expense—two 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.
May 1, 2015
Cash 108,039
(To record the present value of the cash flows)
Cash 2,667
(To record accrued interest; Interest Payable
might be credited instead)
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).
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.
Illustration 14-12 provides the computation, using the effective-interest rate of

6 percent.
ILLUSTRATION 14-12
Interest Expense
Partial Period Interest Carrying value of bonds €108,039
Amortization Effective-interest rate (6% 3 2/12) 3 1%
Interest expense for two months € 1,080
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 com-
puted 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 Cash interest paid on July 1, 2015 (€100,000 3 8% 3 6/12) €4,000
Less: Cash interest received on May 2, 2015 2,667
Amortization
Net cash paid €1,333
Bond interest expense (at the effective rate) for two months (1,080)
Premium amortization € 253
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.
Interest Expense
July 1, 2015
5/1/15 2,667a
7/1/15 4,000b 7/1/15 253c
Cash 4,000
Balance 1,080 (To record first interest payment)
a
Accrued interest received. Bonds Payable 253
b
Cash paid.
c Interest Expense 253
2 months’ amortization.
(To record two-months’ premium amortization)
The Interest Expense account now contains a debit balance of €1,080 (€4,000 2 €2,667 2
€253), which represents the proper amount of interest expense—two months at an effec-
tive 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 closed down the credit supply and raised interest rates on
operate in their own separate worlds. However, in recent already-high levels of debt. The result? Share prices took a hit.
volatile markets, even quiet murmurs in the bond market Other industries are not immune from the negative
have been amplified into movements (usually negative) in shareholder effects of credit problems. For example, analysts
share prices. At one extreme, these gyrations heralded the at TheStreet.com compiled a list of companies with a focus
demise of a company well before the investors could sniff out on debt levels. Companies like Copel CIA (BRA) (an energy
the problem. distribution company) were rewarded with improved share
The swift decline of Enron (USA) in late 2001 provided ratings, based on their manageable debt levels. In contrast,
the ultimate lesson: A company with no credit is no company other companies with high debt levels and low ability to
at all. As one analyst remarked, “You can no longer have an cover interest costs were not viewed very favorably. Among
opinion on a company’s shares without having an apprecia- them is Goodyear Tire and Rubber (USA), which reported
tion for its credit rating.” Indeed, other energy companies debt six times greater than its equity. Goodyear is a classic
also felt the effect of Enron’s troubles as lenders tightened or example of how swift and crippling a heavy debt-load can
Long-Term Notes Payable 665
be. Not too long ago, Goodyear had a good credit rating and share price dropped 80 percent. This was yet another exam-
was paying a good dividend. But, with mounting operating ple of share prices taking a hit due to concerns about credit
losses, Goodyear’s debt became a huge burden, its debt rat- quality. Thus, even if your investment tastes are in equity,
ing fell to junk status, the company cut its dividend, and its 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 17–18, 2005), p. B4.
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
Explain the accounting for long-term
that companies expect to pay within a year or the operating cycle—whichever is
notes payable.
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 corpora-
tions 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 pre-
mium 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 657–664 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.
Cash 10,000
Notes Payable 10,000
Scandinavian Imports would recognize the interest incurred each year as follows.
Interest Expense (€10,000 3 .10) 1,000
Cash 1,000
Notes Not Issued at Face Value

Zero-Interest-Bearing Notes
If a company issues a zero-interest-bearing (non-interest-bearing) note7 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
7
Although we use the term “note” throughout this discussion, the basic principles and method-
ology apply equally to other long-term debt instruments.
Calculator Solution for company records the difference between the face amount and the present value (cash
Effective Interest received) as a discount and amortizes that amount to interest expense over the life of
on Note:
Inputs Answer
the note.
An example of such a transaction is Beneficial Corporation’s (USA) offering of
N 8 $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 $327—a deep discount of $673 each. The
I/YR ? 15 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
PV -327
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
PMT 0 Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Com-
pany illustrated on page 309 of Chapter 7 (notes receivable). The implicit rate that
FV 1,000
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 14-14 shows the time
diagram for the single cash flow.
ILLUSTRATION 14-14
Time Diagram for PV $10,000 Principal
Zero-Interest Note
i = 9%
PV-OA $0 $0 $0 Interest
0 1 2 3
n=3
Turtle Cove records issuance of the note as follows.

Cash 7,721.80
Notes Payable 7,721.80
Turtle Cove amortizes the discount and recognizes interest expense annually using
the effective-interest method. Illustration 14-15 shows the three-year discount amorti-
zation 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
Schedule of Note EFFECTIVE-INTEREST METHOD
Discount Amortization 0% NOTE DISCOUNTED AT 9%
Carrying
Paid Expense Amortized of Note
Date of issue $ 7,721.80
End of year 1 $–0– $ 694.96a $ 694.96b 8,416.76c
End of year 2 –0– 757.51 757.51 9,174.27
End of year 3 –0– 825.73d 825.73 10,000.00
$–0– $2,278.20 $2,278.20
a c
$7,721.80 3 .09 5 $694.96 $7,721.80 1 $694.96 5 $8,416.76
b d
$694.96 2 0 5 $694.96 5¢ adjustment to compensate for rounding.
8
$327 5 $1,000(PVF8,i)
$327
PVF 8,i 5 5 .327
$1,000
.327 5 15% (in Table 6-2 locate .32690).
Turtle Cove records interest expense at the end of the first year using the effective-
interest method as follows.
Interest Expense ($7,721.80 3 9%) 694.96
Notes Payable 694.96
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 dia-
gram 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.
Cash 9,520
Notes Payable 9,520
Marie Co. then amortizes the discount and recognizes interest expense annually using
the effective-interest method. Illustration 14-16 shows the three-year discount amorti-
zation and interest expense schedule.
SCHEDULE OF NOTE DISCOUNT AMORTIZATION

ILLUSTRATION 14-16
EFFECTIVE-INTEREST METHOD Schedule of Note
10% NOTE DISCOUNTED AT 12% Discount Amortization
Carrying
Paid Expense Amortized of Note
Date of issue € 9,520
End of year 1 €1,000a €1,142b €142c 9,662d
End of year 2 1,000 1,159 159 9,821
End of year 3 1,000 1,179 179 10,000
€3,000 €3,480 €480
a
€10,000 3 10% 5 €1,000 c
€1,142 2 €1,000 5 €142
b
€9,520 3 12% 5 €1,142 d
€9,520 1 €142 5 €9,662
Marie Co. records payment of the annual interest and amortization of the discount
for the first year as follows (amounts per amortization schedule).
Notes Payable 142
Cash 1,000
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. No interest rate is stated, or

2. The stated interest rate is unreasonable, or
3. The stated face amount of the debt instrument is materially different from the cur-
rent 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? No—if they did, Health Spa’s Land account and Scenic’s sales would be over-
stated 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
Health Spa, Inc. (Buyer) Scenic Development Company (Seller)
Entries for Non-Cash
Land 200,000 Notes Receivable 200,000
Note Transaction
Notes Payable 200,000 Sales Revenue 200,000
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 determin-
able 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 determin-
ing 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 approxi-
mation 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
PV Time Diagram for
£550,000 Principal
Interest-Bearing Note
i = 8%
PV-OA £11,000 £11,000 £11,000 £11,000 £11,000 Interest
0 1 2 3 4 5
n=5
The present value of the note and the imputed fair value of the architectural ser-
vices are determined as follows.
ILLUSTRATION 14-19
Face value of the note £ 550,000
Present value of £550,000 due in 5 years at 8% interest payable Computation of Imputed
annually (Table 6-2); FV(PVF5,8%); (£550,000 3 .68058) £374,319 Fair Value and Note
Present value of £11,000 interest payable annually for 5 years at 8%; Discount
R(PVF-OA5,8%); (£11,000 3 3.99271) 43,920
Present value of the note (418,239)
Discount on notes payable £131,761
Wunderlich records issuance of the note in payment for the architectural services as
follows.
December 31, 2015

Buildings (or Construction in Process) 418,239
The five-year amortization schedule appears below.
ILLUSTRATION 14-20 SCHEDULE OF NOTE DISCOUNT AMORTIZATION

Schedule of Discount EFFECTIVE-INTEREST METHOD
Amortization Using 2% NOTE DISCOUNTED AT 8% (IMPUTED)
Imputed Interest Rate
Cash Interest Carrying
Paid Expense Discount Amount
Calculator Solution for Date (2%) (8%) Amortized of Note
the Fair Value of Services:
12/31/15 £418,239
Inputs Answer 12/31/16 £11,000a £ 33,459b £ 22,459c 440,698d
12/31/17 11,000 35,256 24,256 464,954
N 5 12/31/18 11,000 37,196 26,196 491,150
12/31/19 11,000 39,292 28,292 519,442
12/31/20 11,000 41,558e 30,558 550,000
I/YR 8 £55,000 £186,761 £131,761
a d
£550,000 3 2% 5 £11,000 £418,239 1 £22,459 5 £440,698
PV ? 418,241* b e
£418,239 3 8% 5 £33,459 £3 adjustment to compensate for rounding.
c
£33,459 2 £11,000 5 £22,459
PMT –11,000
Wunderlich records payment of the first year’s interest and amortization of the dis-
FV –550,000
count as follows.
*Difference due to rounding. December 31, 2016
Cash 11,000
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 in-
volved. 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 mort-
gage 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 $1,000,000—or $960,000—but 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 approxi-
mately 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 Payable—
Secured,” 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
9
Points, in mortgage financing, are analogous to the original issue discount of bonds.
Special Issues Related to Non-Current Liabilities 671
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 fluctuat-
ing 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
Describe the accounting for
the cash flows of the company, reporting requirements must be substantive and
extinguishment of non-current
informative. Four additional reporting issues related to non-current liabilities liabilities.
are addressed in this section:
1. Extinguishment of non-current liabilities.

2. Fair value option.
3. Off-balance-sheet financing.
4. Presentation and analysis.
Extinguishment of Non-Current Liabilities

How do companies record the payment of non-current liabilities—often referred to as
extinguishment of debt? If a company holds the bonds (or any other form of debt secu-
rity) 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. Extinguishment with cash before maturity,

2. Extinguishment by transferring assets or securities, and
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
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]
amount of the bonds is the amount payable at maturity, adjusted for unamortized pre-
mium 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 SCHEDULE OF BOND DISCOUNT AMORTIZATION

Bond Premium EFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS
Amortization Schedule, 5-YEAR, 8% BONDS SOLD TO YIELD 10%
Bond Extinguishment
Carrying
Date Paid Expense Amortized of Bonds
1/1/15 € 92,278
7/1/15 € 4,000a € 4,614b € 614c 92,892d
1/1/16 4,000 4,645 645 93,537
7/1/16 4,000 4,677 677 94,214
1/1/17 4,000 4,711 711 94,925
7/1/17 4,000 4,746 746 95,671
1/1/18 4,000 4,783 783 96,454
7/1/18 4,000 4,823 823 97,277
1/1/19 4,000 4,864 864 98,141
7/1/19 4,000 4,907 907 99,048
1/1/20 4,000 4,952 952 100,000
€40,000 €47,722 €7,722
a
€4,000 5 €100,000 3 .08 3 6/12 c
€614 5 €4,614 2 €4,000
b
€4,614 5 €92,278 3 .10 3 6/12 d
€92,892 5 €92,278 1 €614
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 com-
putes the loss on redemption (extinguishment).
ILLUSTRATION 14-22
Computation of Loss on Reacquisition price (€100,000 3 1.01) €101,000
Carrying amount of bonds redeemed (94,925)
Redemption of Bonds
Loss on extinguishment € 6,075
Evermaster records the reacquisition and cancellation of the bonds as follows.

Loss on Extinguishment of Debt 6,075
Cash 101,000
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.
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 inter-
est 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.
Notes Payable (to Hamburg Bank) 20,000,000
Loss on Disposal of Real Estate (€21,000,000 2 €16,000,000) 5,000,000
Real Estate 21,000,000
Gain on Extinguishment of Debt (€20,000,000 2 €16,000,000) 4,000,000
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.
Notes Payable (to Hamburg Bank) 20,000,000
Share Capital—Ordinary 3,200,000
Share Premium—Ordinary 12,800,000
Gain on Extinguishment of Debt 4,000,000
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.
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.
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 collec-
tion on the loan. For example, a creditor may offer 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.
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 modifi-
cations 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 experi-
encing 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
Present value of restructured cash flows:
Fair Value of Present value of ¥9,000,000 due in 4 years at 15%,
Restructured Note interest payable annually (Table 6-2); FV(PVF 4,15%);
(¥9,000,000 3 .57175) ¥5,145,750
Present value of ¥720,000 interest payable annually
for 4 years at 15% (Table 6-4); R(PVF-OA4,15%);
(¥720,000 3 2.85498) 2,055,586
Fair value of note ¥7,201,336
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.
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.
Notes Payable (old) 10,500,000
Gain on Extinguishment of Debt 3,298,664
Notes Payable (new) 7,201,336
Illustration 14-24 shows the amortization schedule for the new note, following the
modification.
Date Cash Paid Interest Expense Amortization Carrying Value

ILLUSTRATION 14-24
Schedule of Interest and
12/31/2015 ¥7,201,336 Amortization after Debt
12/31/2016 ¥720,000a ¥1,080,200b ¥360,200c 7,561,536d
Modification
12/31/2017 720000 1,134,230 414,230 7,975,767
12/31/2018 720000 1,196,365 476,365 8,452,132
12/31/2019 720000 1,267,820 547,868 9,000,000
a c
¥9,000,000 3 8% ¥1,080,200 2 ¥720,000
b d
¥7,201,336 3 15% ¥7,201,336 1 ¥360,200
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 re-
structure), Resorts Development makes the following entry.
December 31, 2016

Interest Expense 1,080,200
Cash 720,000
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.
December 31, 2019

Notes Payable 9,000,000
Cash 9,000,000
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

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, compa- Describe the accounting for the fair
value option.
nies 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 314–315), the IASB believes that fair value measurement for financial instru-
ments, including financial liabilities, provides more relevant and understandable infor-
mation 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 ex-
pense 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.
Bonds Payable (€500,000 2 €480,000) 20,000
Unrealized Holding Gain or Loss—Income 20,000
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

Underlying Concepts 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
The fair value controversy because the bonds become more likely to default. That is, if the creditworthi-
represents a classic trade-off ness of Edmonds Company declines, the value of its debt also declines. If its
between relevance and faithful creditworthiness declines, its bond investors are receiving a lower rate relative
representation. 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 creditwor-
thiness 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 sharehold-
ers’ 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.
Unrealized Holding Gain or Loss—Equity 20,000
This entry recognizes the decline in the fair value of the liability and a resulting unreal-
ized 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
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
Explain the reporting of off-balance-
off-balance-sheet financing to minimize the reporting of debt on their state- sheet financing arrangements.
ments of financial position.14 Off-balance-sheet financing is an attempt to bor-
row 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. Non-consolidated subsidiary. Under IFRS, a parent company does not have to con-
solidate 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 subsid-
iary. As a result, users of the financial statements may not understand that the sub-
sidiary has considerable debt for which the parent may ultimately be liable if the
subsidiary runs into financial difficulty.
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. Operating leases. Another way that companies keep debt off the statement of finan-
cial 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.
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.
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 commit-
ments might not be considered in computing debt limits.
Third, some argue that the asset side of the statement of financial position is se-
verely 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 financ-
ing will occur in the future.16
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. Finan-
cial 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.
Evolving Issue OFF-AND-ON REPORTING
The off-balance-sheet world is slowly but surely becoming In addition, companies must disclose off-balance-sheet
more on-balance-sheet. New rules on guarantees and con- arrangements and contractual obligations that currently
solidation of SPEs are doing their part to increase the amount have, or are reasonably likely to have, a material future effect
of debt reported on corporate statements of financial posi- on the companies’ financial condition. Presented below is
tion. See footnote 15 (page 678) for a discussion of the IASB’s Novartis Group’s (CHE) tabular disclosure of its contractual
consolidation guidance. obligations. Because Novartis lists its securities in the United
States, it is subject to U.S. SEC rules.
Novartis Group
Contractual Obligations
The following table summarizes the Group’s contractual obligations and other commercial commitments as well as the
effect these obligations and commitments are expected to have on the Group’s liquidity and cash flow in future periods:
Payments due by period

Less than After
Total 1 year 2–3 years 4–5 years 5 years
USD millions USD millions USD millions USD millions USD millions
Non-current financial debt 15,790 2,009 5,823 2,006 5,952
Operating leases 3,145 372 467 293 2,013
Unfunded pensions and other
post-retirement obligations 2,144 97 195 207 1,645
Research & Development
–Unconditional commitments 219 48 79 59 33
–Potential milestone commitments 2,014 456 526 766 266
Purchase commitments
–Property, plant & equipment 755 508 236 11
Total contractual cash obligations 24,067 3,490 7,326 3,342 9,909
The Group expects to fund the R&D and purchase commitments with internally generated resources.
Enron’s (USA) abuse of off-balance-sheet financing to reporting of contractual obligations. We believe the new U.S.
hide debt was shocking and inappropriate. One silver lining SEC rule, which requires companies to report their obliga-
in the Enron debacle, however, is that the standard-setting tions over a period of time, will be extremely useful to the
bodies are now providing increased guidance on companies’ 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
Indicate how to present and analyze
with comments and schedules in the accompanying notes. Long-term debt that
non-current liabilities.
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, con-
vert 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]
Note disclosures generally indicate the nature of the liabilities, maturity dates, inter-
est 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.
Novartis Group
(in millions)
Dec. 31, Dec. 31,

2012 2011
Total current assets $28,004 $24,084
Non-current liabilities
Financial debt 13,781 13,855
Deferred tax liabilities 7,286 6,761
Provisions and other non-current liabilities 9,879 7,792
Total non-current liabilities 30,946 28,408
Current liabilities
Trade payables 5,593 4,989
Financial debts and derivative financial instruments 5,945 6,374
Current income tax liabilities 2,070 1,706
Provisions and other current liabilities 10,443 10,079
Total current liabilities 24,051 23,148
Total liabilities $54,997 $51,556
19. Non-Current Financial Debts (in part) 2012 2012 2011 2011
Balance Fair Balance Fair
2012 2011 Fair value comparison sheet values sheet values
Straight bonds $14,783 $13,483 Straight bonds $14,783 $16,130 $13,483 $14,794
Liabilities to banks and other financial Others 1,007 1,007 1,150 1,150
institutions1 1,004 1,146
Total $15,790 $17,137 $14,633 $15,944
Finance lease obligations 3 4
Total (including current portion of Collateralized non-current financial
non-current financial debt) 15,790 14,633 debt and pledged assets 2012 2011
Less current portion of non-current Total amount of collateralized non-current
financial debt 22,009 2778 financial debts $ 12 $ 7
Total non-current financial debts $13,781 $13,855 Total net book value of property, plant &
1
equipment pledged as collateral for
Average interest rate 0.8% (2011: 0.9%) non-current financial debt $136 $100
2012 2011
Breakdown by maturity 2012 $ 778 The Group’s collateralized non-current financial debt consists of
2013 $ 2,009 2,029 loan facilities at usual market conditions.
2014 2,713 2,789 The percentage of fixed rate financial debt to total financial
2015 3,110 3,108 debt was 80% at December 31, 2012, and 72% at the end of 2011.
2016 1,987 1,948 Financial debt, including current financial debt, contains only
2017 19 3 general default covenants. The Group is in compliance with these
After 2017 5,952 3,978 covenants.
The average interest rate on total financial debt in 2012 was
Total $15,790 $14,633
2.9% (2011: 2.7%, 2010: 3.1%).
2012 2011
Breakdown by currency USD $11,943 $ 9,962
EUR 2,043 2,042
JPY 929 1,031
CHF 869 1,589
Others 6 9
Total $15,790 $14,633
ILLUSTRATION 14-25
Long-Term Debt
Disclosure
Global Accounting Insights 681
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
Total Liabilities
Debt to Assets 5 Computation of Debt
Total Assets
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
Income before Income Taxes and Interest Expense
Times Interest Earned 5 Computation of Times
Interest Expense
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
$54,997
Debt to assets 5 5 44% Computation of Long-
$124,216
Term Debt Ratios for
1$9,618 1 $1,625 1 $7242 Novartis
Times interest earned 5 5 16.5 times
$724
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. are substantial differences in terminology related to non-
In addition, the accounting for current liabilities is essentially current liabilities as well as some differences in the accounting
the same under both IFRS and U.S. GAAP. However, there for various types of long-term debt transactions.
Relevant Facts
Similarities • U.S. GAAP and IFRS are similar in the treatment of en-
• As indicated above, U.S. GAAP and IFRS have similar vironmental liabilities. However, the recognition criteria
liability definitions. Both also classify liabilities as current for environmental liabilities are more stringent under U.S.
and non-current. GAAP: Environmental liabilities are not recognized unless
• Much of the accounting for bonds and long-term notes is there is a present legal obligation and the fair value of the
the same under U.S. GAAP and IFRS. obligation can be reasonably estimated.
• Both U.S. GAAP and IFRS require the best estimate of a • U.S. GAAP uses the term troubled debt restructurings and
probable loss. In U.S. GAAP, the minimum amount in a develops recognition rules related to this category. IFRS
range is used. Under IFRS, if a range of estimates is pre- generally assumes that all restructurings should be consid-
dicted and no amount in the range is more likely than any ered extinguishments of debt.
other amount in the range, the midpoint of the range is • Under U.S. GAAP, companies are permitted to use the
used to measure the liability. straight-line method of amortization for bond discount or
• Both U.S. GAAP and IFRS prohibit the recognition of premium, provided that the amount recorded is not ma-
liabilities for future losses. terially different than that resulting from effective-interest
amortization. However, the effective-interest method is
Differences preferred and is generally used. Under IFRS, companies
• Under U.S. GAAP, companies must classify a refinancing as must use the effective-interest method.
current only if it is completed before the financial statements • Under U.S. GAAP, companies record discounts and pre-
are issued. IFRS requires that the current portion of long-term miums in separate accounts (see the About the Numbers
debt be classified as current unless an agreement to refinance section). Under IFRS, companies do not use premium or dis-
on a long-term basis is completed before the reporting date. count accounts but instead show the bond at its net amount.
• U.S. GAAP uses the term contingency in a different way • Under U.S. GAAP, bond issue costs are recorded as an
than IFRS. A contingency under U.S. GAAP may be re- asset. Under IFRS, bond issue costs are netted against the
ported as a liability under certain situations. IFRS does not carrying amount of the bonds.
permit a contingency to be recorded as a liability. • Under U.S. GAAP, losses on onerous contract are generally
• U.S. GAAP uses the term estimated liabilities to discuss not recognized unless addressed by industry- or transaction-
various liability items that have some uncertainty related to specific requirements. IFRS requires a liability and related
timing or amount. IFRS generally uses the term provisions. expense or cost be recognized when a contract is onerous.
About the Numbers

Under IFRS, premiums and discounts are netted against the balance and is used for bonds issued at a discount). Evermaster
face value of the bonds for recording purposes. Under U.S. makes the following entry on the first interest payment date.
GAAP, discounts and premiums are recorded in separate July 1, 2015
accounts. To illustrate, consider the €100,000 of bonds dated
Interest Expense (€108,530 3 6% 3 1⁄2) 3,256
January 1, 2015 (8 percent coupon, paid semiannually),
Premium on Bonds Payable (€4,000 2 €3,256) 744
issued by Evermaster to yield 6 percent on January 1, 2015.
Cash (€100,000 3 8% 3 1⁄2) 4,000
Recall from the discussion on page 661 that the price of these
bonds was €108,530. Using U.S. GAAP procedures, Evermaster Following this entry, the net carrying value of the bonds is
makes the following entry to record issuance of the bonds. as follows.
Bonds payable €100,000
January 1, 2015
Premium on bonds payable (€8,530 2 €744) 7,786
Cash 108,530
Bonds Payable 100,000 Carrying value of bonds payable €107,786
Premium on Bonds Payable 8,530 Thus, with a separate account for the premium, entries to re-
(€108,530 2 €100,000)
cord amortization are made to the premium account, which
As indicated, the bond premium is recorded in a separate reduces the carrying value of the bonds to face value over the
account (the account, “Discount on Bonds Payable,” has a debit life of the bonds.
On the Horizon
As indicated in Chapter 2, the IASB and FASB are working are attempting to clarify the accounting related to provisions
on a conceptual framework project, part of which will exam- and related contingencies.
ine the definition of a liability. In addition, the two Boards
Summary of Learning Objectives 683
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES amortization, 659
bearer (coupon)
bonds, 655
1 Describe the formal procedures associated with issuing long-term
bond discount, 657
debt. Incurring long-term debt is often a formal procedure. The bylaws of corporations
bond indenture, 654
usually require approval by the board of directors and the shareholders before corpora-
tions can issue bonds or can make other long-term debt arrangements. Generally, long- bond premium, 657
term debt has various covenants or restrictions. The covenants and other terms of the callable bonds, 655
agreement between the borrower and the lender are stated in the bond indenture or note carrying value, 659
agreement. commodity-backed
bonds, 655
2 Identify various types of bond issues. Various types of bond issues are convertible bonds, 655
(1) secured and unsecured bonds; (2) term, serial, and callable bonds; (3) convertible, debenture bonds, 655
commodity-backed, and deep-discount bonds; (4) registered and bearer (coupon) bonds; debt to assets
and (5) income and revenue bonds. The variety in the types of bonds results from at- ratio, 681
tempts to attract capital from different investors and risk-takers and to satisfy the cash deep-discount (zero-
flow needs of the issuers. interest debenture)
bonds, 655
3 Describe the accounting valuation for bonds at date of issuance. The effective-interest
investment community values a bond at the present value of its future cash flows, which method, 659
consist of interest and principal. The rate used to compute the present value of these effective yield or market
cash flows is the interest rate that provides an acceptable return on an investment com- rate, 657
mensurate with the issuer’s risk characteristics. The interest rate written in the terms of extinguishment of
the bond indenture and ordinarily appearing on the bond certificate is the stated, cou- debt, 671
pon, or nominal rate. The issuer of the bonds sets the rate and expresses it as a percent- face, par, principal, or
age of the face value (also called the par value, principal amount, or maturity value) of maturity value, 656
the bonds. If the rate employed by the buyers differs from the stated rate, the present fair value option, 676
value of the bonds computed by the buyers will differ from the face value of the bonds. imputation, 669
The difference between the face value and the present value of the bonds is either a dis- imputed interest rate, 669
count or premium. income bonds, 655
long-term debt, 654
4 Apply the methods of bond discount and premium amortization. The long-term notes
discount (premium) is amortized and charged (credited) to interest expense over the life payable, 665
of the bonds. Amortization of a discount increases bond interest expense, and amortiza- mortgage notes
tion of a premium decreases bond interest expense. The procedure for amortization of a payable, 670
discount or premium is the effective-interest method. Under the effective-interest off-balance-sheet
method, (1) bond interest expense is computed by multiplying the carrying value of the financing, 677
bonds at the beginning of the period by the effective-interest rate; then, (2) the bond refunding, 673
discount or premium amortization is determined by comparing the bond interest
registered bonds, 655
expense with the interest to be paid.
revenue bonds, 655
5 Explain the accounting for long-term notes payable. Accounting proce- secured bonds, 655
dures for notes and bonds are similar. Like a bond, a note is valued at the present value serial bonds, 655
of its expected future interest and principal cash flows, with any discount or premium special purpose entity
being similarly amortized over the life of the note. Whenever the face amount of the (SPE), 677
note does not reasonably represent the present value of the consideration in the ex- stated, coupon, or
change, a company must evaluate the entire arrangement in order to properly record nominal rate, 656
the exchange and the subsequent interest. substantial
modification, 674 (n)
6 Describe the accounting for the extinguishment of non-current liabil- term bonds, 655
ities. Non-current liabilities, such as bonds and notes payable, may be extinguished by times interest earned, 681
(1) paying cash, (2) transferring non-cash assets and/or granting of an equity interest, zero-interest debenture
and (3) modification of terms. At the time of extinguishment, any unamortized pre- bonds, 655
mium 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 recog-
nized 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.
7 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, in-
cluding non-current liabilities. Fair value measurement for financial instruments, in-
cluding 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 inter-
est expense recognized but not recorded.
8 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.
9 Indicate how to present and analyze non-current liabilities. Companies

that have large amounts and numerous issues of non-current liabilities frequently re-
port only one amount in the statement of financial position and support this with com-
ments 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 re-
quirements 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.: Interna-
tional Accounting Standards Committee Foundation, 2003), par. 47.
tional Accounting Standards Committee Foundation, 2003), paras. AG64–65.
tional Accounting Standards Committee Foundation, 2003), paras. AG59–61.
Questions 685
tional Accounting Standards Committee Foundation, 2003), par. AG62.
tional Accounting Standards Committee Foundation, 2003), paras. IN16–17.
[8] International Financial Reporting Standard 9, Financial Instruments (London, U.K.: IFRS Foundation, November
2013), paras. 5.7.7–5.7.8.
[9] International Financial Reporting Standard 10, Consolidated Financial Statements (London, U.K.: International Ac-
counting Standards Committee Foundation, May 2011), paras. IN8–IN9.
[10] International Accounting Standard 1, Presentation of Financial Statements (London, U.K.: International Accounting
Standards Committee Foundation, 2003), paras. 69–76.
QUESTIONS
1. (a) From what sources might a corporation obtain funds 12. How is the present value of a non-interest-bearing note
through long-term debt? (b) What is a bond indenture? computed?
What does it contain? (c) What is a mortgage? 13. When is the stated interest rate of a debt instrument pre-
2. Novartis Group (CHE) has issued various types of bonds sumed to be fair?
such as term bonds, income bonds, and debentures. Dif- 14. What are the considerations in imputing an appropriate
ferentiate between term bonds, mortgage bonds, collateral interest rate?
trust bonds, debenture bonds, income bonds, callable
bonds, registered bonds, bearer or coupon bonds, convert- 15. Differentiate between a fixed-rate mortgage and a variable-
ible bonds, commodity-backed bonds, and deep-discount rate mortgage.
bonds. 16. Identify the situations under which debt is extinguished.
3. Distinguish between the following interest rates for bonds 17. What is the “call” feature of a bond issue? How does the call
payable: feature affect the amortization of bond premium or discount?
(a) Yield rate. (d) Market rate. 18. Why would a company wish to reduce its bond indebted-
(b) Nominal rate. (e) Effective rate. ness before its bonds reach maturity? Indicate how this
(c) Stated rate. can be done and the correct accounting treatment for such
4. Distinguish between the following values relative to bonds a transaction.
payable: 19. What are the general rules for measuring a gain or a loss
(a) Maturity value. (c) Market (fair) value. by a debtor in a debt extinguishment?
(b) Face value. (d) Par value. 20. (a) In a debt modification situation, why might the credi-
5. Under what conditions of bond issuance does a discount tor grant concessions to the debtor?
on bonds payable arise? Under what conditions of bond (b) What type of concessions might a creditor grant the
issuance does a premium on bonds payable arise? debtor in a debt modification situation?
6. Briefly explain how bond premium or discount affects in- 21. What are the general rules for measuring and recognizing
terest expense over the life of a bond. gain or loss by a debt extinguishment with modification?
7. What is the required method of amortizing discount and 22. What is the fair value option? Briefly describe the con-
premium on bonds payable? Explain the procedures. troversy of applying the fair value option to financial
8. Zopf Company sells its bonds at a premium and applies liabilities.
the effective-interest method in amortizing the premium. 23. Pierre Company has a 12% note payable with a carrying
Will the annual interest expense increase or decrease over value of €20,000. Pierre applies the fair value option to this
the life of the bonds? Explain. note; given an increase in market interest rates, the fair
9. Vodafone (GBR) recently issued debt. How should the value of the note is €22,600. Prepare the entry to record the
costs of issuing these bonds be accounted for? fair value option for this note.
10. Will the amortization of a bond discount increase or de- 24. What disclosures are required relative to long-term debt
crease bond interest expense? Explain. and sinking fund requirements?
11. What is done to record properly a transaction involving 25. What is off-balance-sheet financing? Why might a com-
the issuance of a non-interest-bearing long-term note in pany be interested in using off-balance-sheet financing?
exchange for property? 26. What are some forms of off-balance-sheet financing?
27. Explain how a non-consolidated subsidiary can be a form December 31. Prepare the entries under U.S. GAAP for
of off-balance-sheet financing. Diaz for (a) date of issue, (b) first interest payment date,
28. Briefly describe some of the similarities and differences be- and (c) January 1, 2016, when Diaz calls and extinguishes
tween U.S. GAAP and IFRS with respect to the accounting the bonds at 101.
for liabilities. 30. Briefly discuss how accounting convergence efforts ad-
29. Diaz Company issued $100,000 face value, 9% coupon dressing liabilities are related to the IASB/FASB concep-
bonds on January 1, 2014, for $92,608 to yield 11%. tual framework project.
The bonds mature in 5 years and pay interest annually on
BRIEF EXERCISES
(All calculations are to be rounded to nearest whole currency unit, unless otherwise stated.)
3 BE14-1 Whiteside Corporation issues ¥500,000 of 9% bonds, due in 10 years, with interest payable semi-
annually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the
bonds.
3 4 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.
3 4 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.
3 4 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.
3 4 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.
3 4 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%.
3 4 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.
3 4 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.
5 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.
5 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.
5 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.
5 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.
6 BE14-13 On January 1, 2015, Henderson Corporation retired $500,000 of bonds at 99. At the time of retire-
ment, the unamortized premium was $15,000. Prepare Henderson’s journal entry to record the reacquisi-
tion of the bonds.
Exercises 687
6 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.
6 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.
7 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.
9 BE14-17 At December 31, 2015, Hyasaki Corporation has the following account balances:
Bonds payable, due January 1, 2023 $1,912,000

Interest payable 80,000
Show how the above accounts should be presented on the December 31, 2015, statement of financial
position, including the proper classifications.
EXERCISES
2 E14-1 (Classification of Liabilities) Presented below are various account balances.
(a) Bank loans payable of a winery, due March 10, 2018. (The product requires aging for 5 years before
sale.)
(b) Serial bonds payable, €1,000,000, of which €250,000 are due each July 31.
(c) Amounts withheld from employees’ wages for income taxes.
(d) Notes payable due January 15, 2017.
(e) Credit balances in customers’ accounts arising from returns and allowances after collection in full
of account.
(f) Bonds payable of €2,000,000 maturing June 30, 2016.
(g) Overdraft of €1,000 in a bank account. (No other balances are carried at this bank.)
(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.
2 E14-2 (Classification) The following items are found in the financial statements.
(a) Interest expense (credit balance).
(b) Bond issue costs.
(c) Gain on repurchase of debt.
(d) Mortgage payable (payable in equal amounts over next 3 years).
(e) Debenture bonds payable (maturing in 5 years).
(f) Notes payable (due in 4 years).
(g) Income bonds payable (due in 3 years).
Instructions
Indicate how each of these items should be classified in the financial statements.
3 4 E14-3 (Entries for Bond Transactions) Presented below are two independent situations.
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. 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.
(a) The issuance of the bonds.
(b) The payment of interest on July 1.
(c) The accrual of interest on December 31.
3 4 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.
(b) The payment of interest and the related amortization on July 1, 2015.
(c) The accrual of interest and the related amortization on December 31, 2015.
3 4 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.)
(b) The payment of interest and related amortization on July 1, 2015.
(c) The accrual of interest and the related amortization on December 31, 2015.
3 4 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 annu-
ally on January 1.
Instructions
Set up a schedule of interest expense and discount amortization. (Hint: The effective-interest rate must be
computed.)
3 4 E14-7 (Determine Proper Amounts in Account Balances) Presented below are three independent
situations.
Instructions
(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.
(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. Deter-
mine the amount of interest expense to record if financial statements are issued on October 31, 2015.
(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.
3 4 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
(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.
Exercises 689
(b) Show the proper statement of financial position presentation for the liability for bonds payable on
the December 31, 2015, statement of financial position.
(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.
3 4 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
(a) Prepare the journal entry at the date of the bond issuance.
(b) Prepare a schedule of interest expense and bond amortization for 2015–2017.
(c) Prepare the journal entry to record the interest payment and the amortization for 2015.
(d) Prepare the journal entry to record the interest payment and the amortization for 2017.
3 4 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.
(a) $10 million, 10-year, 13% unsecured bonds, interest payable quarterly. Bonds were priced to
yield 12%.
(b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year.
(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.
5 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
(a) Record the two journal entries that should be recorded by McLean Company for the two pur-
chases on January 1, 2015.
(b) Record the interest at the end of the first year on both notes.
5 E14-12 (Imputation of Interest) Presented below are two independent situations.
Instructions
(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.
(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.
5 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
(a) Prepare the journal entry to record the initial transaction on January 1, 2015.
(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.
3 4 E14-14 (Entry for Retirement of Bond; Bond Issue Costs) On January 2, 2012, Prebish Corporation issued
6 $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
(a) Determine the price of the Prebish bonds when issued on January 2, 2012.
(b) Prepare an amortization schedule for 2012–2016 for the bonds.
(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.
3 4 E14-15 (Entries for Retirement and Issuance of Bonds) On June 30, 2007, Mendenhal Company issued
6 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
(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.
(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.
3 4 E14-16 (Entries for Retirement and Issuance of Bonds) Kobiachi Company had bonds outstanding with
6 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 ear-
lier 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.
6 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
(a) Prepare journal entries for Strickland Company to record this debt settlement.
(b) How should Strickland report the gain or loss on the disposition of machine and on restructuring
of debt in its 2015 income statement?
(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.
6 E14-18 (Loan Modification) On December 31, 2015, Sterling Bank enters into a debt restructuring agree-
ment 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.
Problems 691
Instructions
(a) Can Barkley Company record a gain under the term modification mentioned above? Explain.
(b) Prepare the amortization schedule of the note for Barkley Company after the debt modification.
(c) Prepare the interest payment entry for Barkley Company on December 31, 2017.
(d) What entry should Barkley make on January 1, 2019?
6 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
(a) Prepare the journal entries to record the loan modification for Barkley.
(b) Prepare the amortization schedule of the note for Barkley Company after the debt modification.
(c) Prepare the interest payment entries for Barkley Company on December 31 of 2016, 2017, and 2018.
(d) What entry should Barkley make on January 1, 2019?
6 E14-20 (Entries for Settlement of Debt) Consider the following independent situations.
Instructions
(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.
(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.
7 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).
Carrying Value Fair Value
December 31, 2015 €54,000 €54,000
December 31, 2016 44,000 42,500
December 31, 2017 36,000 38,000
Instructions
(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.
(b) At what amount will the note be reported on Fallen’s 2016 statement of financial position?
(c) What is the effect of recording the fair value option on these notes on Fallen’s 2017 income?
(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.
(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?
9 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.
PROBLEMS
3 4 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 state-
ments are prepared once yearly.
Amortization Schedule
Amount
Year Cash Interest Unamortized Book Value
1/1/2009 €5,651 € 94,349
2009 €11,000 €11,322 5,329 94,671
2010 11,000 11,361 4,968 95,032
2011 11,000 11,404 4,564 95,436
2012 11,000 11,452 4,112 95,888
2013 11,000 11,507 3,605 96,395
2014 11,000 11,567 3,038 96,962
2015 11,000 11,635 2,403 97,597
2016 11,000 11,712 1,691 98,309
2017 11,000 11,797 894 99,106
2018 11,000 11,894 100,000
Instructions
(a) Indicate whether the bonds were issued at a premium or a discount and how you can determine this
fact from the schedule.
(b) Determine the stated interest rate and the effective-interest rate.
(c) On the basis of the schedule, prepare the journal entry to record the issuance of the bonds on
January 1, 2009.
(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.)
(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.
3 4 P14-2 (Issuance and Retirement of Bonds) Venzuela Co. is building a new hockey arena at a cost of
6 $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
(a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014.
(b) Prepare a bond amortization schedule up to and including January 1, 2018.
(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.
3 4 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 pay-
ment 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 quar-
terly payments would be made over 3 years. For the first year, Good-Deal required a €400 quarterly pay-
ment 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
(a) Prepare a note amortization schedule for the first year.
(b) Indicate the amount the customer owes on the contract at the end of the first year.
(c) Compute the amount of the new quarterly payments.
(d) Prepare a note amortization schedule for these new payments for the next 2 years.
(e) What do you think of the new sales promotion used by Good-Deal?
4 P14-4 (Effective-Interest Method) Samantha Cordelia, an intermediate accounting student, is having dif-
ficulty 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.
Problems 693
Instructions
Using the data above for illustrative purposes, write a short memo (1–1.5 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.)
5 P14-5 (Entries for Zero-Interest-Bearing Note) On December 31, 2015, Faital Company acquired a com-
puter 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
(a) Prepare the journal entry for the purchase on December 31, 2015.
(b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortization
on December 31, 2016.
(c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31,
2017.
5 P14-6 (Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis Cosmetics Co. pur-
chased 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 pur-
chase price.
Instructions
Prepare the journal entries that would be recorded for the purchase and for the payments and interest on
the following dates.
(a) December 31, 2014. (d) December 31, 2017.
(b) December 31, 2015. (e) December 31, 2018.
(c) December 31, 2016.
3 4 P14-7 (Issuance and Retirement of Bonds; Income Statement Presentation) Chen Company issued its
6 9
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
(a) Prepare journal entries to record the issuance of the 11% bonds and the retirement of the 9%
bonds.
(b) Indicate the income statement treatment of the gain or loss from retirement and the note disclosure
required.
3 4 P14-8 (Comprehensive Bond Problem) In each of the following independent cases, the company closes
6 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.)
3 4 P14-9 (Issuance of Bonds Between Interest Dates, Retirement) Presented below are selected transactions
6 on the books of Simonson Corporation.
July 1, 2015 Bonds payable with a par value of €900,000, which are dated January 1, 2015, are sold at
119.219 plus accrued interest to yield 10%. They are coupon bonds, bear interest at 12%
(payable annually at January 1), and mature January 1, 2025. (Use interest expense account
for accrued interest.)
Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the amortization
of the proper amount of premium.
Jan. 1, 2016 Interest on the bonds is paid.
Jan. 2 Bonds of par value of €360,000 are called at 102 and extinguished.
Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the proper
amount of premium amortized.
Instructions
Prepare journal entries for the transactions above.
3 4 P14-10 (Entries for Life Cycle of Bonds) On April 1, 2015, Sarkar Company sold 15,000 of its 11%, 15-year,
6 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.
(a) April 1, 2015: issuance of the bonds.
(b) October 1, 2015: payment of semiannual interest.
(c) December 31, 2015: accrual of interest expense.
(d) April 2, 2016: extinguishment of 6,000 bonds. (No reversing entries made.)
5 6 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
(a) What is the accounting nature of this transaction?
(b) Prepare the journal entry to record this refinancing on the books of Perkins Inc.
5 6 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.
(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.
(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.
(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.
6 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 finan-
cial difficulties, the market rate for its loans is 12%.
Instructions
(a) Prepare the amortization schedule for the years 2015 through 2018.
(b) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2015, 2016, and
2017.
Concepts for Analysis 695
3 4 P14-14 (Comprehensive Problem: Issuance, Classification, Reporting) Presented below are three inde-
6 9
pendent situations.
Instructions
(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?
(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.
Sinking Fund Maturities
2016 $300,000 $100,000
2017 100,000 250,000
2018 100,000 100,000
2019 200,000 —
2020 200,000 150,000
2021 200,000 100,000
Indicate how this information should be reported in the financial statements at December 31, 2015.
(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.
C O N C E P T S F O R A N A LY S I S
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 posi-
tion that might be used for these bonds at the issue date.
1. Bonds payable (maturing January 1, 2036) $1,085,800
2. Bonds payable—principal (face value $1,000,000 maturing

January 1, 2036) $ 142,050a
Bonds payable—interest (semiannual payment $55,000) 943,750b
Total bond liability $1,085,800
3. Bonds payable—principal (maturing January 1, 2036) $1,000,000

Bonds payable—interest ($55,000 per period for 40 periods) 2,200,000
Total bond liability $3,200,000
a
The present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period.
b
The present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.
Instructions
(a) Discuss the conceptual merit(s) of each of the date-of-issue statement of financial position presen-
tations shown above for these bonds.
(b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.
(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.
(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 transac-
tion 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
(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 posi-
tion prepared immediately after the bond issue was sold.
(b) What items related to the bond issue would be included in Sealy’s 2016 income statement, and
how would each be determined?
(c) Would the amount of bond discount amortization using the effective-interest method of amortiza-
tion be lower in the second or third year of the life of the bond issue? Why?
(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. Amortized over remaining life of old debt.
2. Amortized over the life of the new debt issue.
3. Recognized in the period of extinguishment.
Instructions
(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains
and losses from the early extinguishment of debt.
(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.
Using Your Judgment 697
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 con-
sideration, 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
(a) What are project financing arrangements using special purpose entities?
(b) What are take-or-pay contracts?
(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?
(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 share-
holder 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
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues in this case?
(c) What would you do if you were Donald?
USING YOUR JUDGMENT

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.
(a) What cash outflow obligations related to the repayment of long-term debt does M&S have over the
next 5 years?
(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, respec-
tively. 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.
(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.
(b) What is the difference between the fair value and the historical cost (carrying amount) of each com-
pany’s borrowings at year-end 2012? Why might a difference exist in these two amounts?
(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 YORK—Commonwealth Edison Co.’s slow-selling new 9¼% 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
(a) How will the development above affect the accounting for Commonwealth Edison’s bond issue?
(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
(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?
(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?
(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?
(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.
Bugant, Inc.
Statement of Financial Position
December 31, 2015
Assets
Plant and equipment (net of accumulated
depreciation of €160) €1,840
Inventory €1,800
Cash 450
Total current assets 2,250
Total assets €4,090
Equity
Share capital €1,500
Retained earnings 1,164
Liabilities
Bonds payable (net of discount) 1,426
Total equity and liabilities €4,090
Note X: Long-Term Debt

On January 1, 2014, Bugant issued bonds with face value of €1,500 and coupon rate
equal to 10%. The bonds were issued to yield 12% and mature on January 1, 2019.
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 finan-
cial 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.)
(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?
(b) If all goes well with the plant expansion, the financial performance of Wie Company could dra-
matically 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 borrow-
ing 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.
© KWW_Professional _Simulation
Non-Current Time Remaining

copy paste calculator sheet standards
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help spliter done
Liabilities 4 hours 30 minutes
Directions Situation Journal Entry Analysis Financial Statements Resources
Balzac Inc. has been producing quality children’s apparel for more than 25 years. The company’s
fiscal year runs from April 1 to March 31. The following information relates to the obligations of Balzac
as of March 31, 2015.
Bonds Payable
Balzac issued €5,000,000 of 11% bonds on April 1, 2014. Market interest rates on that date for bonds
of similar risk were 10%. Bonds mature on April 1, 2024; interest is paid annually on April 1.
Notes Payable
Balzac has signed several long-term notes with financial institutions and insurance companies.
The maturities of these notes are given in the schedule below. The total unpaid interest for all of
these notes amounts to €210,000 on March 31, 2015.
Due Date Amount Due
April 1, 2015 € 200,000
July 1, 2015 300,000
October 1, 2015 150,000
January 1, 2016 150,000
April 1, 2016–March 31, 2017 600,000
April 1, 2017–March 31, 2018 500,000
€1,900,000
Environmental Liability
Balzac purchased a warehouse in 2010 for €300,000. In February 2015, due to the passage of a new
wetlands restoration law, Balzac will be required to restore the wetlands surrounding the warehouse
site when the warehouse is abandoned in 2019. Balzac has estimated that the present value of the cost
to restore the site is €35,000.
Prepare the journal entry for the issuance of the bonds and on the first interest payment date.
Use a spreadsheet to prepare an amortization schedule for the bonds.
Prepare the non-current liabilities section of the statement of financial position and appropriate notes
to the financial statements for Balzac Inc. as of March 31, 2015.
Remember to check the book’s companion website, at www.wiley.com/

college/kieso, to find additional resources for this chapter.

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CHAPTER

5 Explain the accounting for long-term notes payable.

Current Global Public Debt

Sources: A. Sakoui and N. Bullock, “Companies Choose Bonds for

As our opening story indicates, companies may rely on different

Bonds Payable Long-Term Notes Payable Special Issues

• Issuing bonds • Notes issued at face value • Extinguishments

LEARNING OBJECTIVE 2 Types and Ratings of Bonds

What do the numbers mean? ALL ABOUT BONDS

Issuer Coupon Maturity Price Yield Rating

on June 4, 2018. The Telecom Italia bonds pay 5.25 percent, a

Valuation of Bonds Payable

Bonds Issued at Par

It records the first interest payment as follows.

Bonds Issued at Discount or Premium

ILLUSTRATION 14-4 Present value of the principal:

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

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

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

Underlying Concepts Bonds Issued at a Discount

ILLUSTRATION 14-6 Maturity value of bonds payable €100,000

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

ILLUSTRATION 14-7 SCHEDULE OF BOND DISCOUNT AMORTIZATION

Evermaster records the issuance of its bonds at a discount on January 1, 2015, as

Bonds Issued at a Premium

The five-year amortization schedule appears in Illustration 14-9.

SCHEDULE OF BOND PREMIUM AMORTIZATION

Evermaster records the issuance of its bonds at a premium on January 1, 2015, as

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

Evermaster records this accrual as follows.

Bonds Issued Between Interest Dates

Bonds Issued at Discount or Premium

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

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

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

LONG-TERM NOTES PAYABLE

Notes Issued at Face Value

Notes Not Issued at Face Value

Turtle Cove records issuance of the note as follows.

SCHEDULE OF NOTE DISCOUNT AMORTIZATION

Special Notes Payable Situations

1. No interest rate is stated, or

Choice of Interest Rate

note under such circumstances, a company must approximate an applicable interest

December 31, 2015

The five-year amortization schedule appears below.

ILLUSTRATION 14-20 SCHEDULE OF NOTE DISCOUNT AMORTIZATION

Mortgage Notes Payable

SPECIAL ISSUES RELATED TO NON-CURRENT

1. Extinguishment of non-current liabilities.

Extinguishment of Non-Current Liabilities

1. Extinguishment with cash before maturity,

Extinguishment with Cash before Maturity

ILLUSTRATION 14-21 SCHEDULE OF BOND DISCOUNT AMORTIZATION

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

Extinguishment by Exchanging Assets or Securities

Extinguishment with Modiﬁcation of Terms

1. Reduction of the stated interest rate.

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