Chapter Three

Long-Term Liabilities
Characteristics of Bonds
Debenture bonds. Debenture bonds are bonds that are not secured by specific property. Their
marketability is based on the general credit rating of the company. Generally, a company must
have a long-period of earnings and continued favorable predictions of future earnings and
liquidity to sell debenture bonds. Debenture bondholders are considered to be general creditors,
with the same rights as other creditors if the issuer fails to pay the interest or principal and
declares bankruptcy.
Mortgage Bonds. Mortgage bonds are bonds that are secured by a lien against specific property
of the company. If the company becomes bankrupt and is liquidated, the holders of these bonds
have first claim against the proceeds of the sale of the assets that secured their debt. If the
proceeds from the sale of pledged assets are not sufficient to repay the debt, mortgage
bondholders become general creditors for the balance of the unpaid debt.

Registered Bonds. Registered bonds are bonds whose ownership is registered with the company.
That is, the company maintains a record of the holder of each bond. Therefore, on each interest
payment date, interest is paid to the individuals listed on the corporate records as owners of the
bonds. When an owner sells registered bonds, the issuer or transfer agent must be notified so that
interest will be paid to the proper person.

Coupon Bonds. Coupon bonds are unregistered bonds on which interest is claimed by the holder
presenting a coupon to the company. These bonds can be transferred between individuals without
the company or its agent being notified.

Zero-Coupon Bonds. Zero-coupon bonds (also called deep-discount bonds) are bonds on which
the interest is not paid until the maturity date. That is, the bonds are sold at a price considerably
below their face value, interest accrues until maturity, and then the bondholders are paid the
interest along with the principal at maturity.

Callable Bonds. Callable bonds are bonds that are callable by the company at a predetermined
price for a specified period. That is, the company has the right to require the bondholders to
return the bonds before the maturity date, with the company paying the predetermined price and
interest to date.

 Convertible Bonds. Convertible bonds are bonds that are convertible into a
predetermined number of shares. That is, the owner of each bond has the right to
exchange it for a
predetermined number of shares of the company. Thus, upon conversion, the bondholder
becomes a stockholder of the company.

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  Serial Bonds. Serial bonds are bonds issued at one time, but portions of the total face
value mature in periodic installments at different future dates. Bonds with several
maturities.

 Term Bonds. Term bonds are bonds that pay the entire principal on one date, i.e. at the
maturity date. Bonds with single maturity.

 Income (Revenue) Bonds. These are bonds whose payment of interest is conditional on
income.

Reasons for Issuance of Long-term Debt

Borrowing, which results in a long-term liability, is one of the choices available to companies
seeking to obtain financial resources. There are five basic reasons why a company might issue
long-term debt rather than offer other types of securities.

1. Debt financing may be the only available source of funds. Many small- and medium
sized companies may appear too risky to investors to attract equity (i.e., capital stock)
investments. Debt securities issued by a company may be a less risky investment because
by law interest is required to be paid on each interest payment date. Also, some types of
debt are secured by a lien against specific company assets.

2. Debt financing may have a lower cost. Historically, since debt has a lesser investment
risk than stock, it usually has offered a relatively lower rate of return. In general,
investors in equity securities have earned a higher return. However, because market
conditions change, the cost of debt financing varies, so this advantage depends on the
particular market conditions.

3. Debt financing offers an income tax advantage. Interest payments to debt holders are
deductible by a corporation as interest expense for income tax purposes, whereas
dividend payments on equity securities are not.

4. The voting privilege is not shared. Corporate stockholders may not wish to share
ownership. Thus, by issuing debt, which does not provide voting rights, ownership
interests are not diluted.

5. Debt financing offers the opportunity for leverage. The term leverage (or trading on the
equity) refers to a company’s use of borrowed funds. By investing these funds, the
company expects to earn a return greater than the interest it will pay for their use and
thereby benefit the stockholders. Earnings in excess of interest charges (net of the
applicable income tax reduction) increase earnings per share. However, if the return falls
below the effective interest rate, earnings per share will decline. Expectations of current
and future earnings, inflation, and the debt/equity relationship influence the rate of
interest needed to issue debt.

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 Non-current liabilities (long-term debt) consist of an expected outflow of resources arising
from present obligations that are not payable within a year or the operating cycle of the
company, whichever is longer.
Examples:
► Bonds payable ► Pension liabilities
► Long-term notes payable ► Lease liabilities
► Mortgages payable
I. Bonds Payable
Issuing Bonds
 Bond contract known as a bond indenture.
 Represents a promise to pay:
(1) sum of money at designated maturity date, plus
(2) periodic interest at a specified rate on the maturity amount (face value).
 Paper certificate, typically a €1,000 face value.
 Interest payments usually made semiannually.
 Used when the amount of capital needed is too large for one lender to supply.
II. Types of Bonds
Common types found in practice:
 Secured and Unsecured (debenture) bonds.
 Term, Serial, and Callable bonds.
 Convertible, Commodity-Backed, Deep-Discount bonds.
 Registered and Bearer (Coupon) bonds.
 Income and Revenue bonds.
III. Valuation of Bonds Payable at Issuance
Issuance and marketing of bonds to the public:
 Usually takes weeks or months.
 Issuing company must
► Arrange for underwriters.
► Obtain regulatory approval of the bond issue, undergo audits, and issue a
prospectus.
► Have bond certificates printed.
Selling price of a bond issue is set by the
 supply and demand of buyers and sellers,
 relative risk,
 market conditions, and
 state of the economy.
 Investment community values a bond at the present value of its expected future cash
flows, which consist of (1) interest and (2) principal.

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Interest Rate
 Stated, coupon, or nominal rate = Rate written in the terms of the bond
indenture.
► Bond issuer sets this rate.
► Stated as a percentage of bond face value (par).
 Market rate or effective yield = Rate that provides an acceptable return
commensurate with the issuer’s risk.
► Rate of interest actually earned by the bondholders
How do you calculate the amount of interest that is actually paid to the bondholder each period?

(Stated rate x Face Value of the bond)

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

(Market rate x Carrying Value of the bond)

Assume Stated Rate of 8%

Market
6% Bonds Sold
Premium
8%
Interest Par At
Value
10% Discount
Bonds Issued at Par
Illustration: 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.

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Journal entry on date of issue, Jan. 1, 2015.
Cash 100,000
Bonds payable 100,000
Journal entry to record accrued interest at Dec. 31, 2015.
Interest expense 9,000
Interest payable 9,000
Journal entry to record first payment on Jan. 1, 2016.
Interest payable 9,000
Cash 9,000
Bonds Issued at a Discount
Illustration: Assuming 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.

Journal entry on date of issue, Jan. 1, 2015.

Cash 92,608
Bonds payable 92,608
Journal entry to record accrued interest at Dec. 31, 2015.
Interest expense ($92,608 x 11%) 10,187
Interest payable 9,000
Bonds payable 1,187
Journal entry to record first payment on Jan. 1, 2016.
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Interest payable 9,000
Cash 9,000
When bonds sell at less than face value:
► Investors demand a rate of interest higher than stated rate.
► Usually occurs because investors can earn a higher rate on alternative
investments of equal risk.
► Cannot change stated rate so investors refuse to pay face value for the bonds.
► Investors receive interest at the stated rate computed on the face value, but they
actually earn at an effective rate because they paid less than face value for the
bonds.
Bond Discount & Premium Amortization
Bond issued at a discount - amount paid at maturity is more than the issue amount.
Bonds issued at a premium - company pays less at maturity relative to the issue price.
Adjustment to the cost is recorded as bond interest expense over the life of the bonds through a
process called amortization.
Required procedure for amortization is the effective-interest method (also called present value
amortization).
Effective-Interest Method
Effective-interest method produces a periodic interest expense equal to a constant percentage
of the carrying value of the bonds.

Illustration: Evermaster Corporation issued €100,000 of 8% term bonds on January 1, 2015,

due on January 1, 2020, with interest payable each July 1 and January 1. Investors require an
effective-interest rate of 10%. Calculate the bond proceeds.

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Journal entry on date of issue, Jan. 1, 2015.
Cash 92,278
Bonds Payable 92,278
Journal entry to record first payment and amortization of the discount on July 1, 2015.
Interest expense 4,614
Bonds payable 614
Cash 4,000
Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2015.
Interest expense 4,645
Interest payable 4,000
Bonds payable 645
Illustration: Evermaster Corporation issued €100,000 of 8% term bonds on January 1, 2015,
due on January 1, 2020, with interest payable each July 1 and January 1. Investors require an
effective-interest rate of 6%. Calculate the bond proceeds.

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Journal entry on date of issue, Jan. 1, 2015.
Cash 108,530
Bonds payable 108,530
Journal entry to record first payment and amortization of the premium on July 1, 2015.
Interest expense 3,256
Bonds payable 744
Cash 4,000
Accrued Interest
What happens if Evermaster prepares financial statements at the end of February 2015? In this
case, the company prorates the premium by the appropriate number of months to arrive at the
proper interest expense, as follows.

Evermaster records this accrual as follows.

Interest expense 1,085.33
Bonds payable248.00
Interest payable 1,333.33

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Bonds Issued between Interest Dates
Bond investors will pay the seller the interest accrued from the last interest payment date to the
date of issue.
On the next semiannual interest payment date, bond investors will receive the full six months’
interest payment.
 When companies issue bonds on other than the interest payment dates, buyers of the
bonds will pay the seller the interest accrued from the last interest payment date to
the date of issue.
 The purchasers of the bonds, in effect, pay the bond issuer in advance for that portion of
the full six-months’ interest payment to which they are not entitled because they have not
held the bonds for that period.
 Then, on the next semiannual interest payment date, purchasers will receive the full
six-months’ interest payment.

Illustration: Assume Evermaster issued its five-year bonds, dated January 1, 2015, on May 1,
2015, at par (€100,000). Evermaster records the issuance of the bonds between interest dates as
follows.
(€100,000 x .08 x 4/12) = €2,667
Cash 100,000
Bonds payable 100,000
Cash 2,667
Interest expense 2,667
On July 1, 2015, two months after the date of purchase, Evermaster pays the investors six
months’ interest, by making the following entry.
($100,000 x .08 x 1/2) = $4,000
Interest expense 4,000
Cash 4,000

Illustration: Assume that the Evermaster 8% bonds were issued on May 1, 2015, to yield 6%.
Thus, the bonds are issued at a premium price of €108,039. Evermaster records the issuance of
the bonds between interest dates as follows.

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Cash 108,039
Bonds payable 108,039
Cash 2,667
Interest expense 2,667
Evermaster then determines interest expense from the date of sale (May 1, 2015), not from the
date of the bonds (January 1, 2015).

The premium amortization of the bonds is also for only two months.

Evermaster therefore makes the following entries on July 1, 2015, to record the interest payment
and the premium amortization.
Interest expense 4,000
Cash 4,000
Bonds payable253
Interest expense 253

Long-term Notes Payable

Accounting is Similar to Bonds
 A note is valued at the present value of its future interest and principal cash flows.
 Company amortizes any discount or premium over the life of the note.
Illustration: 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.
(a) Cash 100,000
Notes payable 100,000
(b) Interest expense 10,000
Cash 10,000
(€100,000 x 10% = €10,000)
Zero-Interest-Bearing Notes
Issuing company records the difference between the face amount and the present value (cash
received) as
 a discount and
 amortizes that amount to interest expense over the life of the note.
Illustration: Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to
Jeremiah Company. The implicit rate that equated the total cash to be paid ($10,000 at maturity)

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to the present value of the future cash flows ($7,721.80 cash proceeds at date of issuance) was 9
percent.

Turtle Cove records issuance of the note as follows.

Cash 7,721.80
Notes Payable 7,721.80

Turtle Cove records interest expense for year 1 as follows.

Interest Expense ($7,721.80 x 9%) 694.96
Notes Payable 694.96

Interest-Bearing Notes
Illustration: 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. 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

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Marie Co. records the following entry at the end of year 1.
Interest Expense 1,142
Notes Payable 142
Cash 1,000
Special Notes Payable Situations
Notes Issued for Property, Goods, or Services
When exchanging the debt instrument for property, goods, or services in a bargained transaction,
the stated interest rate is presumed to be fair unless:
1. No interest rate is stated, or
2. The stated interest rate is unreasonable, or
3. The stated face amount is materially different from the current cash price for the same or
similar items or from the current fair value of the debt instrument.
Choice of Interest Rates
If a company cannot determine the fair value of the property, goods, services, or other rights,
and if the note has no ready market, the present value of the note must be determined by the
company to approximate an applicable interest rate (imputation).
Choice of rate is affected by:
► Prevailing rates for similar instruments.
► Factors such as restrictive covenants, collateral, payment schedule, and the
existing prime interest rate.
Illustration: 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.

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On December 31, 2015, Wunderlich records issuance of the note in payment for the architectural
services as follows.
Building (or Construction in Process) 418,239
Notes Payable 418,239

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

Interest Expense 33,459
Notes Payable 22,459
Cash 11,000
Mortgage Notes Payable
A promissory note secured by a document called a mortgage that pledges title to property as
security for the loan.
 Common form of long-term notes payable.
 Payable in full at maturity or in installments.

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  Fixed-rate mortgage.
 Variable-rate mortgages.
Accounting for Serial Bonds

At the beginning of 2006; a company issued $500,000 of ten-year, 10% serial bonds, to be repaid
in the amount of $50,000 each year. The bond issue costs were $25,000. Assume that interest
payments are made annually and that the bonds are issued to yield:
Case 1 9% p.a.
Case 2 11% p.a.
Case 1: Bonds are issued to yield 9%
a. Proceeds of bond issue = PV (I) + PV (P)
A B A+B A+B (1+i)-n
End of Interest Principal Total Discount Present
Due Due Amount Due Factor (9%) value
2006 50,000 50,000 100,000 0.917 91,700
2007 45,000 50,000 95,000 0.842 79,990
2008 40,000 50,000 90,000 0.772 69,480
2009 35,000 50,000 85,000 0.708 60,180
2010 30,000 50,000 80,000 0.650 52,000
2011 25,000 50,000 75,000 0.596 44,700
2012 20,000 50,000 70,000 0.547 38,290
2013 15,000 50,000 65,000 0.502 32,630
2014 10,000 50,000 60,000 0.460 27,600
2015 5,000 50,000 55,000 0.422 23,210
Totals 275,000 500,000 775,000 519,780
Proceeds of Serial Bond issue @ 9% yield 519,780
b. Premium on bond issue
Total proceeds……………………………………$519,780
Face value……………………………………………500,000
Premium…………………………………………......19,780
c. Journal entry for the issuance of the serial bonds
Cash……………………………………519,780
Bonds payable…………………………………….519,780
d. Premium amortization table for the serial bonds using the interest method
A B C D
Year Carrying Interest Interest Premium Bond Cumulative
Amount Expense Payment Amortization Premium Bal. Principal
(9%*CV) (10%*FV) (C-B) (BB-D) Payment
Issue 519,780 - - - 19,780 -
2006 466,560 46,780 50,000 3,220 16,560 50,000
2007 413,550 41,990 45,000 3,010 13,550 100,000
2008 360,770 37,220 40,000 2,780 10,770 150,000
2009 308,239 32,469 35,000 2,531 8,239 200,000

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 2010 255,981 27,742 25,000 2,258 5,981 250,000
2011 204,019 23,038 20,000 1,962 4,019 300,000
2012 152,381 18,362 15,000 1,638 2,381 350,000
2013 101,095 13,714 10,000 1,286 1,095 400,000
2014 50,194 9,099 5,000 901 194* 450,000
2015 - 4,517 483* - 500,000
*Rounding up difference
Journal entry to record the retirement of the first serial bond and the payment of the first interest
for 1996:
Bonds payable……………………….53, 220
Bond Interest Expense…………….46,780
Cash 100,000
Case 2: Bonds are issued to Yield 11%
a. Proceeds of bond issue = PV (I) + PV (P)
A B A+B (1+i)-n A+B (1+i)-n
End of Interest Principal Total Amount Discount Present
Due Due Due factor (11%) value
1996 50,000 50,000 100,000 0.901 90,100
1997 45,000 50,000 95,000 0.812 77,140
1998 40,000 50,000 90,000 0.731 65,790
1999 35,000 50,000 85,000 0.659 56,015
2000 30,000 50,000 80,000 0.593 47,440
2001 25,000 50,000 75,000 0.535 40,125
2002 20,000 50,000 70,000 0.482 33,740
2003 15,000 50,000 65,000 0.434 28,210
2004 10,000 50,000 60,000 0.391 23,460
2005 5,000 50,000 55,000 0.352 19,360
Totals 275,000 500,000 775,000 481,380
Proceeds of Serial Bond issue @ 11% yield 481,380
b. Discount on bond issue
Face value……………………………………………500,000
Total proceeds……………………………………$481,380
Discount ………………………………………….......18,620
c. Journal entry to record the issuance of the bonds
Cash ………………………………………….481,380
Bonds Payable…………………………………..481,380
d. Discount amortization table using the interest method
Year Carrying Interest Interest Discount Bond Cumulative
Amount Expense Payment Amortization Discount Principal
(11%) (10%) Balance Payment
Issue 481,380 - - - 18,620 -
1996 434,332 52,952 50,000 2,952 15,668 50,000
1997 387,109 47,777 45,000 2,777 12,891 100,000

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 1998 339,691 42,582 40,000 2,582 10,309 150,000
1999 292,057 37,366 35,000 2,366 7,943 200,000
2000 244,183 32,126 25,000 2,126 5,817 250,000
2001 196,043 26,860 20,000 1,860 3,957 300,000
2002 147,608 21,565 15,000 1,565 2,392 350,000
2003 98,845 16,237 10,000 1,237 1,155 400,000
2004 49,718 10,873 5,000 873 282* 450,000
2005 - 5,469 496* - 500,000
*Rounding up difference
e. Journal entry to record the retirement of the first serial bond and the payment of the first
interest for 1996:
Bonds payable [50000-2952]……47048
Bond Interest Expense…………..52,952
Cash………………………………… 100,000
Special Issues Related To Non-current Liabilities
Extinguishment of Non-Current Liabilities (repurchase or retirement of its outstanding bonds)
1. Extinguishment with cash before maturity,
2. Extinguishment by transferring assets or securities, and
3. Extinguishment with modification of terms.
Retirement of bonds at maturity. There is no recognition of any gain or loss on retirement, as
the carrying value is equal to the maturity value, which is also equal to the market value of the
bonds at that point.
Extinguishment with Cash before Maturity
When debt is retired prior to maturity, a gain or loss must be recognized for the difference
between the carrying value of the debt and the amount paid to satisfy the obligation.
 Net carrying amount > Reacquisition price = Gain
 Reacquisition price > Net carrying amount = Loss
 At time of reacquisition, unamortized premium or discount must be amortized
up to the reacquisition date.
 If the redemption occurs between interest payment dates, adjusting entries must be made
to recognize the accrued interest and to amortize the bond discount or premium.
Illustration: 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% paid semiannually, and
were sold to yield 10%.

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Two years after the issue date on January 1, 2017, Evermaster calls the entire issue at 101 and
cancels it.

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

Bonds Payable 94,925
Loss on Extinguishment of Bonds 6,075
Cash 101,000
Extinguishment by Exchanging Assets or Securities
 Creditor should account for the non-cash assets or equity interest received at
their fair value.
 Debtor recognizes a gain equal to the excess of the carrying amount of the
payable over the fair value of the assets or equity transferred (gain).
Exchanging Assets
Illustration: 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.
Note Payable (to Hamburg Bank) 20,000,000
Loss on Disposal of Real Estate 5,000,000
Real Estate 21,000,000
Gain on Extinguishment of Debt 4,000,000
Exchanging Securities
Illustration: 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

Extinguishment with Modification of Terms

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.
Illustration: On December 31, 2015, Morgan National Bank enters into a debt modification
agreement with Resorts Development Company. The bank restructures a ¥10,500,000 loan
receivable issued at par (interest paid to date) by:

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 ► 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.

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
Note Payable (old) 10,500,000
Gain on Extinguishment of Debt 3,298,664
Note Payable (new) 7,201,336
Amortization schedule for the new note.

Presentation of Non-Current Liabilities

Note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call
provisions, conversion privileges, restrictions imposed by the creditors, and assets designated or pledged
as security.
Fair value of the debt should be disclosed. Must disclose future payments for sinking fund requirements
and maturity amounts of long-term debt during each of the next five years.

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