Intermediate Accounting, Long-term Liabilities

term bonds

Bond issues that mature on a single date.

callable bonds

Bonds that give the issuer the right to call and retire the bonds prior to maturity.

Describe the formal procedures associated with issuing long-term debt.

Incurring long-term debt is often a formal procedure. The bylaws of corporations usually require approval by the board of directors and the stockholders before corporations can issue bonds or can make other long-term debt arrangements. Generally, long-term debt has various covenants or restrictions. The covenants and other terms of the agreement between the borrower and the lender are stated in the bond indenture or note agreement.

zero-interest debenture bonds

Long-term, unsecured debt securities that do not bear interest. They are sold at a discount that provides the buyer's total interest payoff at maturity. Also called deep-discount bonds.

deep-discount (zero-interest) debenture bonds

Long-term, unsecured debt securities that do not bear interest. They are sold at a discount that provides the buyer's total interest payoff at maturity. Also called zero-interest debenture bonds.

long-term notes payable

Similar in substance, in that both have fixed maturity dates and carry a stated or implicit interest rate, but notes do not trade as readily as bonds in the organized public securities market.

times interest earned ratio

Solvency ratio that indicates the company's ability to meet interest payments as they come due. Computed as income before income taxes and interest expense divided by interest expense.

bond discount

The difference between the face value of a bond and its selling price when the bond sells for less than face value.

bond premium

The difference between the face value of a bond and its selling price when the bond sells for more than face value.

carrying value

The face amount of a bond minus any unamortized discount, or plus any unamortized premium. Synonymous with the term book value.

stated, coupon, or nominal rate

The interest rate written in the terms of the bond indenture (and often printed on the bond certificate). The issuer of the bonds sets this rate, expressed as a percentage of the bond's face value.

imputation

The process of interest-rate approximation, which occurs when a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market.

imputed interest rate

The result of interest-rate approximation, which occurs when a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market.

Describe the accounting for a debt restructuring.

There are two types of debt settlements: (1) transfer of noncash assets, and (2) granting of equity interest. Creditors and debtors record losses and gains on settlements based on fair values. For accounting purposes there are also two types of restructurings with continuation of debt with modified terms: (1) the carrying amount of debt is less than the future cash flows, and (2) the carrying amount of debt exceeds the total future cash flows. Creditors record losses on these restructurings based on the expected future cash flows discounted at the historical effective interest rate. The debtor determines its gain based on undisclosed cash flows.

debenture bonds

Unsecured bonds, which are issued against the general credit of the borrower (issuer).

Identify various types of bond issues.

Various types of bond issues are: (1) Secured and unsecured bonds. (2) Term, serial bonds, and callable bonds. (3) Convertible, commodity-backed, and deep-discount bonds. (4) Registered and bearer (coupon) bonds. (5) Income and revenue bonds. The variety in the types of bonds results from attempts to attract capital from different investors and risk takers and to satisfy the cash flow needs of the issuers (borrowers).

The bond contract is called __

an indenture. This term is often confused with the term "debenture". A debenture bond is an unsecured bond.

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The denomination of a band __

is called the face value. Synonymous terms are par value, principal amount, maturity value, and face amount.

An interest payment promised by a bond is computed by __

multiplying the bond's par value by its stated interest rate. The amount is often referred to as the cash interest or stated interest.

When the accounting period ends on a date other than an interest date, __

the amortization schedule for a bond or a note payable is unaffected by this fact. That is, the schedule is prepared and computations are made according to the bond periods, ignoring the details of the accounting period. The interest expense amounts shown in the amortization schedule are apportioned to the appropriate accounting period(s).

The rate of interest actually earned by bondholders is called __

the effective, yield, or market rate.

Examples of off-balance-sheet arrangements are __

(1) non-consolidated subsidiaries, (2) special purpose entities, and (3) operating leases.

Why do companies engage in off-balance sheet financing?

A major reason is that many believe that removing debt enhances the quality of the balance sheet 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, because these types of commitments might not be considered in computing the debt limitation. Third, some argue that the asset side of the balance sheet is severely understated.

mortgage notes payable

A promissory note secured by a document called a mortgage, which pledges title to property as security for the loan.

bond indenture

A contract for a bond that represents a promise to pay a sum of money at a designated maturity rate, plus periodic interest at a specified rate on the maturity amount (face value).

special purpose entity (SPE)

A legal entity created to perform a special activity (issue securities, complete a project, perform R&D activities). The company that creates the SPE guarantees that it or some outside party will eventually perform the activity. Use of the SPE enables the company that created it to avoid reporting any assets or liabilities related to the activities on its balance sheet.

Why do some believe that companies should report assets at fair value?

A major reason companies engage in off-balance-sheet financing - because they believe the asset side of the equation is understated, and that off-balance-sheet financing is necessary to offset these lower values.

Describe the accounting procedures for the extinguishment of debt.

At the time of reacquisition, the unamortized premium or discount and any cost of issue applicable to the debt 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 net carrying amount of the debt is the amount payable at maturity, adjusted for unamortized premium or discount and issue costs. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the net carrying amount is a loss from extinguishment. Gains and losses on extinguishments are recognized currently in income and are reported in Other Gains and Losses section of the income statement.

serial bonds

Bond issues that mature in installments. School or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy frequently use serially maturing bonds.

secured bonds

Bonds backed by a pledge of some sort of collateral. For example, mortgage bonds are secured by a claim on real estate; collateral trust bonds are secured by stocks and bonds of other corporations.

registered bonds

Bonds issued in the name of the owner. At redemption or in a sale of the bond, they require surrender of the certificate.

__ are examples of long-term liabilities.

Bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease obligations

commodity-backed bonds

Bonds that are redeemable in measures of a commodity (e.g., barrels of oil, tons of coal, or ounces of rare metal). Also called asset-linked bonds. The accounting problem for such bonds is to project their maturity value in markets where commodity prices fluctuate.

revenue bonds

Bonds that pay interest from specified revenue sources (e.g., airports, school districts, counties, toll-road authorities, and governmental bodies).

income bonds

Bonds that pay no interest unless the issuing company is profitable.

convertible bonds

Bonds that permit holders to exchange them for ("convert them to") other securities of a corporation (typically common stock) for a specified time after issuance.

bearer (coupon) bonds

Bonds without the name of the owner, which may be transferred from one owner to another by mere delivery.

off-balance-sheet financing

Borrowing funds in a way that avoids recording the obligations. Examples of such arrangements are nonconsolidated subsidiaries, special purpose entities, and operating leases. Companies engage in off-balance-sheet financing as a way to remove debt from the balance sheet or bypass loan covenants. In response to off-balance-sheet financing gone bad (e.g., Enron), the FASB has increased disclosure (note) requirements related to this type of financing.

Indicate how to present and analyze long-term debt.

Companies that have large amounts and numerous issues of long-term debt frequently report only one amount in the balance sheet and support this with comments and schedules in the accompanying notes. Any assets pledged as security for the debt should be shown in the assets section of the balance sheet. Disclosure is required of future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next 5 years. Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency.

debt to total assets ratio

Coverage ratio that measures the percentage of the total assets provided by creditors. Computed as total debt divided by total assets. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

straight-line method

Method for computing bond amortization. Under the straight-line method, companies amortize a constant amount each year. Although the FASB recommends the effective-interest method, companies may use a straight-line method if the results obtained are not materially different from those produced by the effective-interest method.

troubled-debt restructuring

Occurs when a creditor grants to the debtor, due to the debtor's financial difficulties, concessions that it would not otherwise consider. A troubled-debt restructuring involves either (1) settlement of debt at less than its carrying amount, or (2) continuation of debt with a modification of terms.

face, par, principal, or maturity value

On a bond, the amount of capital that must be repaid at maturity. The terms face value, par value, principal amount, or maturity value are used interchangeably.

long-term debt

Probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Examples are: bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities.

Apply the methods of bond discount and premium amortization.

The discount (premium) is amortized and charged (credited) to interest expense over the period of time that the bonds are outstanding. Amortization of a discount increases bond interest expense and amortization of a premium decreases bond interest expense. The profession's preferred procedure for amortization of a discount or premium is the effective interest method. Under the effective interest method, (1) bond interest expense is computed by multiplying the carrying value of the bonds a the beginning of the period by the effective interest rate, and (2) the bond discount or premium amortizatin is then determined by comparing the bond interest expense with the interest to be paid for the same interest period.

Describe the accounting valuation for bonds at the date of issuance.

The investment community values a bond at the present value of its future cash flows, which consists of interest and 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 ordinarily appearing on the bond certificate is the stated, coupon, or nominal rate. The issuer of the bonds sets the rate and expresses it as a percentage of the face value (also called the par value, principal amount, or maturity value) of the bonds. If the rate employed by the buyers differs from the stated rate, the present value of the bonds computed by the buyers will differ from the face value of the bonds. The difference between the face value and the present value of the bond is either a discount or a premium.

extinguishment of debt

The payment of debt. If a company holds a debt security to maturity, it does not compute any gains or losses; the carrying amount will equal the maturity (face) value of the bond. If a company extinguishes debt prior to maturity, it must calculate any gain or loss from extinguishment and report such gain or loss in net income.

effective-interest method

The preferred procedure for computing the amortization of a discount or premium. Under this method, companies compute bond interest expense (revenue) at the beginning of the period by the effective-interest rate) and then subtract bond interest paid (calculated as the face amount of the bonds times the stated interest rate); the result is the amortization amount.

effective yield, or market rate

The rate of interest the bondholders actually earn on a bond (and which takes into account the frequency of compounding). If bonds sell at a discount, the effective yield exceeds the stated rate; if bonds sell at a premium, the effective yield is lower than the stated rate.

refunding

The replacement of an existing bond issue with a new one. A company may find it advantageous to acquire its entire outstanding bond issue and replace it with a new bond issue bearing a lower rate of interest. The company should recognize as income the gain from the refunding in the period of redemption.

The life of a bond is measured __

by the time between the date of issuance and the date of maturity. The bond's life is shorter than the term of the bond if the bond is issued on a date later than it is dated.

In addition, the SEC, in response to the Sarbanes-Oxley Act of 2002, now requires companies to provide related information in their management discussion and analysis sections. Specifically, __

companies must disclose (1) all contractual obligations in a tabular format and (2) contingent liabilities and commintments in either a textual or tabular format.

The Discount on Bonds Payable account is a __

contra liability account so its balance should be deducted from Bonds Payable on the balance sheet. The Premium on Bonds Payable account is an adjunct type valuation account so its balance should be added to the balance of Bonds Payable on the balance sheet. Unamortized Bond Issuance Costs are to be classified as a deferred charge in the "Other Assets" classification on the balance sheet; they should be amortized over the bond's life using the straight-line method.

Using the straight-line of amortization, interest expense is determined by __

either adding the amount of discount amortization to the cash interest or deducting the amount of premium amortization from the cash interest. The period amount of amortization is determined by dividing the issuance premium or discount by the number of periods in the bond's life.

Bond prices are quoted __

in terms of percentage of par. Thus, a bond with a par value of $4,000 and a price quote of 102 is currently selling for a price of $4,080 (102% of $4,000). A bond with a quote of 100 is selling for its par value.

Note disclosures generally (related to presentation of Long-term debt) __

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. Companies should show any assets pledged as security for the debt in the assets section of the balance sheet. The fair value of the long-term debt should also be disclosed if it is practical to estimate fair value. Finally, companies must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

Bond prices vary __

inversely with changes in the market rate of interest. This means that as the market rate of interest goes down, bond prices goes up; and as the market rate of interest goes up, bond prices go down. It also means that at the date of issuance, if the market rate of interest is below the stated rate, the price will be above par; likewise, if the market rate is above the stated rate, the issuance price will be below par. Hence, a premium or a discount is an adjustment to interest via an adjustment to price. The adjustment to interest is recorded by the process of amortizing the premium or discount over the periods the bond is outstanding.

The interest rate written in the bond indenture and __

ordinarily appearing on the bond certificate is known as the stated rate. Synonymous terms are coupon rate, nominal rate, and contract rate.

Long-term debt consists of _

probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the business, whichever is longer.

The effective interest method of amortization is sometimes called __

the interest method or the present value method or the effective method. When the effective interest method is used, the bond's carrying value will equal its present value (assuming the amortization is up to date). The effective interest method is the only amortization method that qualifies as a generally accepted principle (method). However, when the results of applying the straight-line method of amortization are not materially different than the results of using the effective interest method, the straight-line method may be used without being considered a departure from (i.e., a violation of) GAAP.