Chapter 14 Long-Term Liabilities: Questions

*25. What are the types of situations that result in troubled debt?

*25. Two different types of situations result with troubled debt: (1) Impairments, and (2) Restructurings. Restructurings can be further classified into: (a) Settlements. (b) Modification of terms. When a debtor company runs into financial difficulty, creditors may recognize an impairment on a loan extended to that company. Subsequently, the creditor may modify the terms of the loan, or settles it on terms unfavorable to the creditor. In unusual cases, the creditor forces the debtor into bankruptcy in order to ensure the highest possible collection on the loan.

*26. What are the general rules for measuring gain or loss by both creditor and debtor in a troubled-debt restructuring involving a settlement?

*26. A transfer of noncash assets (real estate, receivables, or other assets) or the issuance of the debtor's stock can be used to settle a debt obligation in a troubled debt restructuring. In these situations, the noncash assets or equity interest given should be accounted for at fair value. The debtor is required to determine the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain). Likewise, the creditor is required to determine the excess of the receivable over the fair value of those same assets or equity interests transferred (loss). The debtor recognizes a gain equal to the amount of the excess and the creditor normally would charge the excess (loss) against Allowance for Doubtful Accounts. 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).

*27. (a) In a troubled-debt situation, why might the creditor grant concessions to the debtor? (b) What type of concessions might a creditor grant the debtor in a troubled-debt situation?

*27. (a) The creditor will grant concessions in a troubled debt situation because it appears to be the more likely way to maximize recovery of the investment. (b) The creditor might grant any one or a combination of the following concessions: 1. Reduce the face amount of the debt. 2. Accept non-cash assets or equity interests in lieu of cash in settlement. 3. Reduce the stated interest rate. 4. Extend the maturity date of the face amount of the debt. 5. Reduce or defer any accrued interest.

*28. What are the general rules for measuring and recognizing gain or loss by both the debtor and the creditor in a troubled-debt restructuring involving a modification of terms?

*28. When a loan is restructured, the creditor should calculate the loss due to restructuring by sub-tracting the present value of the restructured cash flows (using the historical effective rate) from the carrying value of the loan. Interest revenue is calculated at the original effective rate applied towards the new carrying value. The debtor will record a gain only if the undiscounted restructured cash flows are less than the carrying value of the loan. If a gain is recognized, subsequent payments will be all principal. There is no interest component. If the undiscounted cash flows exceed the carrying amount, no gain is recognized, and a new imputed interest rate must be calculated in order to recognize interest expense in subsequent periods.

*29. What is meant by "accounting symmetry" between the entries recorded by the debtor and creditor in a troubled-debt restructuring involving a modification of terms? In what ways is the accounting for troubled-debt restructurings non-symmetrical?

*29. "Accounting symmetry" between the entries recorded by the debtor and the creditor in a troubled debt restructuring means that there is a correspondence or agreement between the entries recorded by each party. Impairments are nonsymmetrical because, while the creditor records a loss, the debtor makes no entry at all. Troubled debt restructurings are nonsymmetrical because creditors calculate their losses using the discounted present value of future cash flows, while debtors calculate their gains using the undiscounted cash flows.

*3 0. Under what circumstances would a transaction be recorded as a troubled-debt restructuring by only one of the two parties to the transaction

*30. A transaction would be recorded as a troubled debt restructuring by only the debtor if the amount for which the liability is settled is less than its carrying amount on the debtor's books, but equal to or greater than the carrying amount on the creditor's books. In addition to the situation created by the use of discounted versus undiscounted cash flows by creditors and debtors, this situation can occur when a debtor or creditor has been substituted for one of the parties to the original transaction.

1. (a) From what sources might a corporation obtain funds through long-term debt? (b) What is a bond indenture? What does it contain? (c) What is a mortgage?

1. (a) Funds might be obtained through long-term debt from the issuance of bonds, and from the signing of long-term notes and mortgages. (b) A bond indenture is a contractual agreement (signed by the issuer of bonds) between the bond issuer and the bondholders. The bond indenture contains covenants or restrictions for the protection of the bondholders. (c) A mortgage is a document which describes the security for a loan, indicates the conditions under which the mortgage becomes effective (that is, conditions of default), and describes the rights of the mortgagee under default relative to the security. The mortgage accompanies a formal promissory note and becomes effective only upon default of the note.

10. Will the amortization of Discount on Bonds Payable increase or decrease Bond Interest Expense? Explain.

10. Amortization of Discount on Bonds Payable will increase interest expense. A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can increase the effective rate of interest.

11. What is the "call" feature of a bond issue? How does the call feature affect the amortization of bond premium or discount?

11. The call feature of a bond issue grants the issuer the privilege of purchasing, after a certain date at a stated price, outstanding bonds for the purpose of reducing indebtedness or taking advantage of lower interest rates. The call feature does not affect the amortization of bond discount or premium; because early redemption is not a certainty, the life of the bonds should be used for amortization purposes.

12. Why would a company wish to reduce its bond indebtedness before its bonds reach maturity? Indicate how this can be done and the correct accounting treatment for such a transaction.

12. It is sometimes desirable to reduce bond indebtedness in order to take advantage of lower prevailing interest rates. Also the company may not want to make a very large cash outlay all at once when the bonds mature. Bond indebtedness may be reduced by either issuing bonds callable after a certain date and then calling some or all of them, or by purchasing bonds on the open market and then retiring them. When a portion of bonds outstanding is going to be retired, it is necessary for the accountant to make sure any corresponding discount or premium is properly amortized. When the bonds are extinguished, any gain or loss should be reported in income.

13. How are gains and losses from extinguishment of a debt classified in the income statement? What disclosures are required of such transactions?

13. Gains or losses from extinguishment of debt should be aggregated and reported in income. For extinguishment of debt transactions disclosure is required of the following items: (1) A description of the transactions, including the sources of any funds used to extinguish debt if it is practicable to identify the sources. (2) The income tax effect in the period of extinguishment. (3) The per share amount of the aggregate gain or loss net of related tax effect.

14. What is done to record properly a transaction involving the issuance of a non-interest-bearing long-term note in exchange for property?

14. The entire arrangement must be evaluated and an appropriate interest rate imputed. This is done by (1) determining the fair value of the property, goods, or services exchanged or (2) determining the fair value of the note, whichever is more clearly determinable.

15. How is the present value of a non-interest-bearing note computed?

15. If a note is issued for cash, the present value is assumed to be the cash proceeds. If a note is issued for noncash consideration, the present value of the note should be measured by the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note (whichever is more clearly determinable).

16. When is the stated interest rate of a debt instrument presumed to be fair?

16. When a debt instrument is exchanged 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 current sales price for the same or similar items or from the current market value of the debt instrument.

17. What are the considerations in imputing an appropriate interest rate?

17. Imputed interest is the interest factor (a rate or amount) assumed or assigned which is different from the stated interest factor. It is necessary to impute an interest rate when the stated interest rate is presumed to be unreasonable. The imputed interest rate is used to establish the present value of the debt instrument by discounting, at that imputed rate, all future payments on the debt instrument. In imputing interest, the objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity. In order to accomplish that objective, consideration must be given to (1) the credit standing of the issuer, (2) restrictive covenants, (3) collateral, (4) payment and other items pertaining to the debt, (5) the existing prime interest rate, and (6) the prevailing rates for similar instruments of issuers with similar credit ratings.

18. Differentiate between a fixed-rate mortgage and a variable rate mortgage.

18. A fixed-rate mortgage is a note that requires payment of interest by the mortgagor at a rate that does not change during the life of the note. A variable-rate mortgage is a note that features an interest rate that fluctuates with the market rate; the variable rate generally is adjusted periodically as specified in the terms of the note and is usually limited in the amount of each change in the rate up or down and in the total change that can be made in the rate.

19. What is the fair value option? Briefly describe the controversy of applying the fair value option to financial liabilities.

19. The fair value option is an accounting option where the company can elect to record fair values in their accounts for most financial assets and liabilities, including bonds and notes payable. With bonds at fair value, we assume that the decline in value of the bonds is due to an interest rate increase. In other situations, the decline may occur because the bonds become more likely to default. That is, if the creditworthiness of the issuer declines, the value of its debt also declines. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. Thus, changes in the fair value of bonds payable for a decline in creditworthiness are included as part of income. Some question how a bond issuer can record a gain when its creditworthiness is becoming worse. However, the FASB notes that the debtholders' loss is the shareholders' 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.

2. Potlatch Corporation has issued various types of bonds such as term bonds, income bonds, and debentures. Differentiate between term bonds, mortgage bonds, debenture bonds, income bonds, callable bonds, registered bonds, bearer or coupon bonds, convertible bonds, commodity-backed bonds, and deep discount bonds.

2. If the entire bond matures on a single date, the bonds are referred to as term bonds. Mortgage bonds are secured by real estate. Debenture bonds are unsecured. The interest payments for income bonds depend on the existence of operating income in the issuing company. Callable bonds may be called and retired by the issuer prior to maturity. Registered bonds are issued in the name of the owner and require surrender of the certificate and issuance of a new certificate to complete the sale. A bearer or coupon bond is not recorded in the name of the owner and may be transferred from one investor to another by mere delivery. Convertible bonds can be converted into other securities of the issuing corporation for a specified time after issuance. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity. Deep-discount bonds (also called zero-interest bonds) are sold at a discount which provides the buyer's total interest payoff at maturity.

20. Pierre Company has a 12% note payable with a carrying value of $20,000. Pierre applies the fair value option to this note. Given an increase in market interest rates, the fair value of the note is $22,600. Prepare the entry to record the fair value option for this note.

20. Unrealized Holding Gain or Loss—Income 2,600 .....Notes Payable 2,600

21. What disclosures are required relative to long-term debt and sinking fund requirements?

21. The required disclosures at the balance sheet date are future payments for sinking fund requirements and the maturity amounts of long-term debt during each of the next five years.

22. What is off-balance-sheet financing? Why might a company be interested in using off-balance-sheet financing?

22. Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded. Reasons for off-balance sheet financing are: (1) Many believe removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. (2) Loan covenants are less likely to be violated. (3) The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets.

23. What are some forms of off-balance-sheet financing?

23. Forms of off-balance-sheet financing include (1) investments in non-consolidated subsidiaries for which the parent is liable for the subsidiary debt; (2) use of special purpose entities (SPEs), which are used to borrow money for special projects (resulting in take-or-pay contracts); (3) operating leases, which when structured carefully give the company the benefits of ownership without reporting the liability for the lease payments.

24. Explain how a non-consolidated subsidiary can be a form of off-balance-sheet financing.

24. Under GAAP, a parent company does not have to consolidate 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 balance sheet is the investment in the subsidiary. As a result, users of the financial statements may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty.

3. Distinguish between the following interest rates for bonds payable: (a) Yield rate. (b) Nominal rate. (c) Stated rate. (d) Market rate. (e) Effective rate.

3. (a) Yield rate—the rate of interest actually earned by the bondholders; it is synonymous with the effective and market rates. (b) Nominal rate—the rate set by the party issuing the bonds and expressed as a percentage of the par value; it is synonymous with the stated rate. (c) Stated rate—synonymous with nominal rate. (d) Market rate—synonymous with yield rate and effective rate. (e) Effective rate—synonymous with market rate and yield rate.

4. Distinguish between the following values relative to bonds payable: (a) Maturity value. (b) Face value. (c) Market (fair) value. (d) Par value.

4. (a) Maturity value—the face value of the bonds; the amount which is payable upon maturity. (b) Face value—synonymous with par value and maturity value. (c) Market (fair) value—the amount realizable upon sale. (d) Par value—synonymous with maturity and face value.

5. Under what conditions of bond issuance does a discount on bonds payable arise? Under what conditions of bond issuance does a premium on bonds payable arise?

5. A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can alter the effective rate of interest. A premium on bonds payable results from the opposite conditions. That is, when investors are satisfied with a rate of interest lower than the rate stated on the bonds, they are willing to pay more than the face value of the bonds in order to acquire them, thus reducing their effective rate of interest below the stated rate.

6. How should discount on bonds payable be reported on the financial statements? Premium on bonds payable?

6. Discount (premium) on bonds payable should be reported in the balance sheet as a direct deduction from (addition to) the face amount of the bond. Both are liability valuation accounts.

7. What are the two methods of amortizing discount and premium on bonds payable? Explain each.

7. Bond discount and bond premium may be amortized on a straight-line basis or on an effective-interest basis. The profession recommends the effective-interest method but permits the straight-line method when the results obtained are not materially different from the effective-interest method. The straight-line method results in an even or average allocation of the total interest over the life of the notes or bonds. The effective-interest method results in an increasing or decreasing amount of interest each period. This is because interest is based on the carrying amount of the bond issuance at the beginning of each period. The straight-line method results in a constant dollar amount of interest and an increasing or decreasing rate of interest over the life of the bonds. The effective-interest method results in an increasing or decreasing dollar amount of interest and a constant rate of interest over the life of the bonds.

8. Zopf Company sells its bonds at a premium and applies the effective-interest method in amortizing the premium. Will the annual interest expense increase or decrease over the life of the bonds? Explain.

8. The annual interest expense will decrease each period throughout the life of the bonds. Under the effective-interest method the interest expense each period is equal to the effective or yield interest rate times the book value of the bonds at the beginning of each interest period. When bonds are sold at a premium, their book value declines to face value over their life; therefore, the interest expense declines also.

9. Briggs and Stratton reported unamortized debt issue costs of $5.1 million. How should the costs of issuing these bonds be accounted for and classified in the financial statements?

9. Bond issuance costs should be debited to a deferred charge account for Unamortized Bond Issue Costs and amortized over the life of the issue, separately from but in a manner similar to that used for discount on bonds.