Long term liabilities
LO 5
Accounting for long term notes payable
ACCT 320
Spring 2021
Samia Ali
14-1
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.
14-2
Notes Issued at Face Value
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.
(a) Cash 100,000
Notes payable 100,000
(b) Interest expense 10,000
Cash 10,000
(€100,000 x 10% = €10,000)
14-3
Notes Not Issued at Face Value
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.
14-4
Zero-Interest-Bearing Notes
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) to the present value of the future cash flows ($7,721.80
cash proceeds at date of issuance) was 9 percent.
ILLUSTRATION 14-14
Time Diagram for Zero-Interest Note
14-5
Zero-Interest-Bearing Notes
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) 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
14-6
Zero-Interest-Bearing Notes
ILLUSTRATION 14-15
Schedule of Note
Discount Amortization
14-7
Zero-Interest-Bearing Notes
ILLUSTRATION 14-15
Schedule of Note
Discount Amortization
Turtle Cove records interest expense for year 1 as follows.
Interest Expense ($7,721.80 x 9%) 694.96
Notes Payable 694.96
14-8
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.
ILLUSTRATION 7-16
Computation of
Present Value—
Effective Rate
Different from
Stated Rate
14-9
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
14-10
Interest-Bearing Notes
ILLUSTRATION 14-16
Schedule of Note
Discount Amortization
14-11
Interest-Bearing Notes
ILLUSTRATION 14-16
Schedule of Note
Discount Amortization
Marie Co. records the following entry at the end of year 1.
Interest Expense 1,142
Notes Payable 142
Cash 1,000
14-12
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.
14-13
Special Notes Payable Situations
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.
Dr Building (or Construction in Process) Amount=PV of note
Cr Notes Payable Amount=PV of note
14-14
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.
Fixed-rate mortgage.
Variable-rate mortgages.
14-15
Long term liabilities
LO 6
Describe the accounting for the extinguishment of non-
current liabilities
14-16
Extinguishment of Non-Current Liabilities
1. Extinguishment at maturity.
2. Extinguishment with cash before maturity,
3. Extinguishment by transferring assets or securities, and
4. Extinguishment with modification of terms.
14-17
Extinguishment with Cash before Maturity
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.
14-18
Extinguishment with Cash before Maturity
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%.
14-19
Extinguishment with Cash before Maturity
Two years after the issue date on January 1, 2017, Evermaster
calls the entire issue at 101 and cancels it. ILLUSTRATION 14-22
Computation of Loss on
Redemption of Bonds
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
14-20
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 = Carrying amount of the payable – Fair value of the assets or
equity transferred
why? Because extinguishing debt which has more value than the asset
Where are gains reported?
14-21
Exchanging Assets – Example
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.
FACTS: Loan amount 20,000,000
Real estate value FV 16,000,000 CV 21,000,000
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
14-22
Exchanging Securities - Example
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.
FACTS: LOAN 20,000,000
Shares Par 3,200,000 FV 16,000,000
Gain or loss?
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
14-23
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.
14-24
The term “substantial” as such is very subjective. However, IFRS
assumes that a change is substantial if one of the two following tests
are met:
► Quantitative test: the net present value of the cash flows under the
new terms discounted at the original effective interest rate is at least
10% different from the carrying amount of the original debt. This test is
commonly referred to as the “10% test”.
► Qualitative test: A significant change in the terms and conditions that
is so fundamental that immediate de-recognition is required with no
additional quantitative analysis (e.g., new debt having a different
currency to the old debt, equity instrument embedded in the new debt,
etc.).
14-25
Modification of Terms
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:
► 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.
14-26
Modification of Terms
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.
ILLUSTRATION 14-23
Fair Value of Restructured Note NOTE: FV measured using
prevailing market rates
14-27
Modification of Terms
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, (¥7,201,336).
Note Payable (old) 10,500,000
Gain on Extinguishment of Debt 3,298,664
Note Payable (new) 7,201,336
14-28
Long term liabilities
LO 7
Describe the accounting for fair value option
14-29
Fair Value Option
Companies have the option to record fair value in their
accounts for most financial assets and liabilities, including
bonds and notes payable.
The IASB believes that fair value measurement for financial
instruments, including financial liabilities, provides more
relevant and understandable information than amortized cost.
14-30
Fair Value Option
Fair Value Measurement
Non-current liabilities are recorded at fair value, with unrealized
holding gains or losses reported as part of net income.
Illustrations: 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.
Bonds Payable (€500,000 - €480,000) 20,000
Unrealized Holding Gain or Loss—Income 20,000
14-31
Long term liabilities
LO 8
Explain the reporting of off-balance-sheet financing
arrangements.
ACCT 320
Spring 2021
Samia Ali
14-32
Off-Balance-Sheet Financing
Off-balance-sheet financing is an attempt to borrow
monies in such a way to prevent recording the obligations.
Different Forms:
► Non-Consolidated Subsidiary
► Special Purpose Entity (SPE)
► Operating Leases
Why?
14-33
Long term liabilities
LO 9
Indicate how to present and analyze non-current liabilities.
ACCT 320
Spring 2021
Samia Ali
14-34
Presentation and Analysis
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.
14-35
Presentation and Analysis
Analysis of Non-Current Liabilities
One ratio that provides information about debt-paying ability
and long-run solvency is:
Total Liabilities
Debt to Assets =
Total Assets
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.
14-36
Presentation and Analysis
Analysis of Non-Current Liabilities
A second ratio that provides information about debt-paying
ability and long-run solvency is:
Income before Income Taxes and
Times Interest Expense
Interest =
Earned Interest Expense
Indicates the company’s ability to meet interest payments
as they come due.
14-37
