Chapter 1: Accounting for Financial Liabilities

Objectives

1. To describe long-term liabilities and describe how they are valued

2. To identify the nature and types of long-term liabilities-bond

3. To explain the methods of bond discount and premium amortization

4. To prepare the related journal entries 5. To describe the accounting treatment other

long term liabilities

Long-Term Debt

Consists of present obligations not payable within the operating cycle of the business, or a year whichever is longer.

Long-term creditors have no vote in management affairs and only receive a stated rate of interest regardless of the level of earnings.

Covenants or restrictions, for the protection of both lenders and borrowers, are stated in the bond indenture or note agreement.

Bonds Payable

Arises from a contract known as a bond indenture. Represents a promise to pay the principle at maturity and periodic interest based on the stated interest rate and the face value of the bond

the different types of bonds such as term bonds, serial bonds, secured and unsecured bonds, convertible bonds, commodity-backed bonds, deep discount bonds, registered, and coupon bonds.

Exercise 5.1: Issuance of Bonds Ghostbusters Corporation issues

RM300,000 of 9% bonds, due in 10 years, with interest payable semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds.

Solution for Exercise 5.1 n = 10 x 2 i = 10%/2

PV of the principal:300,000 x 0.37689 113,067PVOA of interest payable:[(9% x 300,000)/2] x 12.46221 168,240Price of bond 281,307

Valuation of Bonds Payable

The price of a bond is determined by the interaction between the bond's stated interest rate and its market rate. a) A bond's price is equal to the sum of the present

value of the principle and the present value of the periodic interest.

b) If the stated rate = the market rate, the bond will sell at par.

c) If the stated rate < the market rate, the bond will sell at a discount.

d) If the stated rate > the market rate, the bond will sell at a premium.

Accounting for the Issuance of Bonds

1. The face value of the bond is always reflected in the bond payable account.

2. When a bond sells at a discount, the difference between the sales price and the face value is debited to Discount on Bonds Payable. This is a contra-account to Bonds

Payable.

Accounting for the Issuance of Bonds (cont.)

3. When a bond sells at a premium, the difference between the sales price and the face value is credited to Premium on Bonds Payable. This is an adjunct account to Bonds Payable.

4. Bonds sold between interest dates.i. The price includes the interest accrued since the

last interest payment.ii. The accrued interest is credited to Bond Interest

Expense.

Exercise 5.2: Bonds Payable

The Goofy Company issued RM200,000 of 8% bonds on 1 Jan 2000. The bonds are due on 1 Jan 2005, with interest payable each 1 July and 1 Jan. Compute the issue price at

a) 100b) 97c) 105

Prepare journal entries for both investee and investor

Solution for Exercise 5.2

at 100 at 97 at 105Investee: (‘000)

Dt Cash 200

Kt Bonds Payable 200

Investee: (‘000)

Dt Cash 194

Dt Disc. bonds 6

Kt Bonds Payable 200

Investee: (‘000)

Dt Cash 210

Kt Bonds Payable 200

Kt Premium Bonds 10

Investor:

Dt Investment 200

Kt Cash 200

Investor:

Dt Investment 194

Kt Cash 194

Investor:

Dt Investment 210

Kt Cash 210

Amortization of bond discounts and premiums Two methods:

1. Effective interest method is the preferred procedure used to calculate periodic

interest expense. The carrying amount of the bonds at the start of the period is multiplied by the effective interest rate to determine the interest expense.

2. Straight-line method may be used if the results are not materially different

from those produced by the effective interest method.

Effective interest method Carrying Value of Bonds = Face Value Plus Premium (or Less

Discount). Interest Payable = Stated Interest Rate <> Face Value of Bonds. Interest Expense = Effective Interest Rate <> Carrying Value of

Bonds. If a premium exists:

Dr Interest Expense XXDr Premium on Bonds Payable XX Cr Interest Payable XX

If a discount exists:Dr Interest Expense XX

Cr Discount on Bonds Payable XXCr Interest Payable XX

Exercise 5.3: Amortization of Bonds PayableDonald Duck Company issued RM600,000 of 10%, 20-year bonds on 1 Jan 2002, at 102. Interest is payable semiannually on 1 July and 1 Jan. Donald Duck Company uses straight-line method of amortization for bond premium/discount.Prepare the journal entries to record:

a)The issuance of the bondsb)The payment of interest on 1 Julyc)The accrual of interest on 31 Dec

Solution for Exercise 5.3

a) Issuance of bonds

Dr Cash (600,000 x 1.02) 612,000

Cr Bonds Payable 600,000

Cr Premium on bond 12,000

b) Payment of interest on July 1

Dr Interest expense 29,700

Dr Premium on bond p/able 300

Cr Cash 30,000

Solution for Exercise 5.3 (cont.)

c) Accrual interest on 31 Dec

Dr Interest expense 29,700

Dr Premium on bond p/able 300

Cr. Account payable 30,000

1 Jan 2003

Dr

Cr.

Exercise 5.4: Amortization of Bonds PayableMickey Mouse Company issued RM600,000 of 10%, 10-year bonds on 1 Jan 2002. Interest is payable semiannually on 1 July and 1 Jan. Mickey Mouse Company uses effective interest method of amortization for bond premium/discount. Assume an effective rate yield of 11.5%Prepare the journal entries to record:

a)The issuance of the bondsb)The payment of interest on 1 Julyc)The accrual of interest on 31 Dec

Solution for Exercise 5.4

a) Mickey Mouse (Issuance of bonds)i=11.5/2, n=10x2

PV 600,000 x 0.10685 = 64,110PVOA 30,000 x 15.5330 = 465,990Price on 1 Jan = 530,100

Dr Cash 530,100Dr Discount on bond 69,900

Cr Bonds payable 600,000

Solution for Exercise 5.4 (cont.)

Cash Interest exp.

Amort. Disc

Balance of Bonds

530,1001 30,000 30,481* 481** 530,581***2 30,000 30,508 508 531,0893 30,000 30538 538 531,627

* 11.5% x 530,100 x 6/12 = 30,481

** 30,481 – 30,000 = 481

*** 530,100 + 481 = 530,581

Solution for Exercise 5.4 (cont.)

b) Interest expense on 1 July

Dr Interest expense 30,481

Cr discount on bond 481

Cr. Cash 30,000

b) Interest expense on 1 Jan

Dr Interest expense 30,508

Cr discount on bond 508

Cr. Interest payable 30,000

Cost of Bonds Issue

The issue of bonds involve numerous costs: Legal and accounting expense, administrative

expense (printing doc/prospectus), underwriting fees.

These costs do NOT represent an asset Methods of recognition:

1. As an expense – charge to income statement immediately

2. As a liability – debited to a deferred charge account

Exercise 5.5:Cost of Bond Issue Assume that Cyber Bhd issued a RM40,000,000

five-year bond at its par value on 1 January 1999. The bond carries a coupon interest of 10% and interest is payable on 31 Dec each year. Costs of issuing the bond, which included underwriting fees, totaled RM1,000,000. The costs were capitalized as a deferred charge and amortized on the straight line method. Show the entries to (a) record the issue of bond on 1 Jan 1999(b) recognize the amortization of the bond issue

cost and interest expense

Solution for Exercise 5.5a) Journal entry to record the issuance of the bond

Dt Cash 39,000,000

Dt Deferred bond 1,000,000

Kt Bonds Payable40,000,000

b) Journal entry to recognize amortization of deferred charge

Dt Amortization expense 200,000

Kt Deferred bond 200,000

c) Journal entry to recognize interest expense

Dt Interest expense 4,000,000

Kt Cash 4,000,000

ISSUE OF BONDS IN BETWEEN OF TWO INTEREST DATES Adjustment for accrued interest should be

done. Accrued interest is calculated for the period in

between of the date of previous interest payment with date of bond is sold.

Cash paid by buyer is the price of the bonds together with the accrued interest.

Price of bonds is the present value of the bond at the date of selling/buying.

Exercise 5.6

Date of bond June 30, 1999

Maturity date June 30, 2004

Date of selling the bond Sept 1, 1999

Date of interest payment Dec 31 and June 30

Stated interest rate 9%

Face value of bond RM200,000

Cumi Bhd purchased bond from Ciki Bhd. The following is the information on the bond.

Prepare journal entries on 1 Sept and 31 Dec

Solution for Exercise 5.6

Issued at parEffective interest rate = 9%Price of bondFace value [PV4.5%, 10 200,000 = 0.64393 x 200,000] 128,786Interest [PVOA4.5%, 10 9,000 = 7.91272 x 9,000] 71,214 Present Value 200,000(+) Increment of bond’s value from 30/6 – 1/9 [200,000 x 9% x 2/12] 3,000Cash 203,000(-) Cash paid for interest from 30/6 – 1/9 [200,000 x 9% x 2/12] (3,000)PRICE OF BOND AT 1/9/99 200,000

Solution for Exercise 5.6 (cont.) Journal entries

Sept 1Dr Cash 203,0001

Cr Interest Payable 3,0002

Bonds Payable 200,000

1. 200,000 + 3,000 (interest)2. 200,000 x 9% x 2/12

Sept 1Dr Investment Bonds 200,000 Interest Receivable 3,000 Cr Cash

203,000

Dec. 31Dr Interest Payable 3,000 Interest Expense 6,0001

Cr Cash 9,000

1. 200,000 x 9% x 4/12

Dec. 31Dr Cash 9,000 Cr Interest Revenue

6,000 Interest Receivable

3,000

Solution for Exercise 5.6 (cont.)

Issued at discountEffective interest rate = 11%Price of bondFace value [PV5.5%, 10 200,000 = 0.58543 x 200,000] 117,086Interest [PVOA5.5%, 10 9,000 = 7.53763 x 9,000] 67,839 Present Value 184,925(+) Increment of bond’s value from 30/6 – 1/9 [184,925 x 11% x 2/12] 3,390Cash 188,315(-) Cash paid for interest from 30/6 – 1/9 [200,000 x 9% x 2/12] (3,000)PRICE OF BOND AT 1/9/99 185,315

Solution for Exercise 5.6 (cont.) Journal entries

Sept 1Dr Cash 188,3151

Disc on Bond 14,6852

Cr Interest Payable 3,0003

Bonds Payable 200,0001. 185,315 + 3,000 (interest)2. 200,000 – 185,3153. 200,000 x 9% x 2/12

Sept 1Dr Investment Bonds 185,315 Interest Receivable 3,000 Cr Cash 188,315

Solution for Exercise 5.6 (cont.)

Date CashPaid

InterestExpense

Amortisation of

discount

Discount not

amortised

Carrying amount of

bond

30/6 - - - 15,075 184,925

31/12 9,000 10,171 1,171 13,905 186,096

30/6 9,000 10,235 1,235 12,669 187,331

Solution for Exercise 5.6 (cont.)

Dec. 31Dr Interest Expense 6,7811

Interest Payable 3,000 Cr Disc on Bonds

7812

Cash 9,000

1. 10,171 x 4/62. 1,171 x 4/6, OR: = 186,096 - 185,315 or = 1,171 – (3,390-3,000)

Dec. 31Dr Investment in Bonds 781 Cash 9,000 Cr Interest Revenue 6,781 Interest Receivable 3,000

RETIREMENT OF BONDSBefore the maturity date Examples of bonds retirement:

1. Refunding2. Converted Bond 3. Callable Bond

At the maturity date If bond is retired at the maturity date, no profit or loss is

recordedCarrying Amount of Bond = Face Value of Bond

Journal entry for payment made at the maturity date:Dr Bonds Payable XX Interest Payable XX Cr Cash XX

Discounts on Bonds Payable XX

Refunding

Bond is retired by issuing new bond. At the retirement, all records on bonds and

any related records to the old bond will be eliminated.

Interest expense and amortisation of discount/premium needs to be recorded in advance until the retirement date.

Example

On January 1, 1995, Wira Company issued RM100,000, 10-year bond at par and with stated interest rate of 5% paid every 30/6 and 31/12. On January 1, 1999, the buyer agreed to receive bond of RM90,000, 20-year, with stated interest rate of 8% paid at the same dates. Market interest rate is 8%.

At the issuance of the bond:1/1/95 Dr Cash 100,000

Cr Bonds Payable 100,000 At refundingValue of new issuance of bond = RM90,000 (at par)1/1/99 Dr Bonds Payable – 5% 100,000

Cr Bonds Payable – 8% 90,000 Cr Gains from retirement 10,000

Converted Bonds

Bonds can be converted into shares Reasons for conversion: to increase the share capital or to

make the bond marketable Entries for issuing of the bonds – 2 methods: excess from sale as equity (separate between debts and

equity) the excess is considered as debts (no separation between

debts and equity) Entries for converting bonds to shares: 2 methods:

1. Book value method2. Fair value method

Methods for Converted bondsa) BOOK VALUE METHOD Record of share and premium at book value of bond at

the conversion date No gain/loss is recorded If fair value of shares > book value of bond there is

a decrease in retained earnings

b) FAIR VALUE METHOD Shares and premium are recorded at fair value of the

issued shares Gain/loss is recognized Gain/loss = Fair Value of the shares - Book Value of the

bonds Gain/loss is considered as ordinary item in an Income

Statement

Exercise 5.7: Converted Bonds Tania Company issued at a premium of RM60

a Rm1,000 bond convertible into 10 shares of ordinary shares (par value RM10). At the time of conversion the unamortised premium is RM 50. The market value of the bond is RM1,200 and the shares is quoted on the market at RM120.

Record the journal entries using:1. Book value method2. Fair value method

Book value method

DR Bond payable 1,000

DR Premium on Bond Payable 50

CR Ordinary shares100

CR Premium shares 950

Fair Value Method

DR Bond payable 1,000

DR Premium on Bond Payable 50

DR Loss on Redemption of Bond 150

CR Ordinary shares100

CR Premium shares 1100

Callable Bonds

Normally the bond is repaid at the maturity date. CAN be repaid at any time if it is called up. Normally the bond is callable when the market

interest decline – refinance at lower rate At the callable date, the company should record all

interest expense and amortise the discount/premium until that date.

When the bond is callable, it is retired. Thus, all record of the bonds and any related to it will be eliminated.

Other Instrument for Long Term Liabilities1. Convertible Bonds (CULS)

• Debt securities that are exchangeable into ordinary shares at the option of the holder and under specified terms and conditions

2. Warrants (Transferable Subscription Rights)

• Gives the holder right to subscribe specific number of shares at the pre-determine exercise price and within a specified period of time

Other Instrument for Long Term Liabilities (cont.)

3. Irredeemable Convertible Loan Stocks (ICULS)

Quasi-debt – pay annual coupon over their tenure but ‘irredeemable’ in future, means there will be no repayment of principle at maturity

Mandatory converted Faced value of ICULS will be converted into

new ordinary shares based on stipulated conversion ratio

Exercise 5.9:ICULS On 1 Jan 2002, Tom & Jerry Company

issues RM1 million ICULS 2002/2006 value at RM1.00 per ICULS. The five-year ICULS paid 7.5% coupon per year. This ICULS can be converted into ordinary shares based on conversion ratio of RM5 ICULS for one new shares (RM1.00, par)

Journal entries at issuance and conversion?

Solution for Exercise 5.9

At IssuanceDR Cash 1,000,000

CR ICULS 1,000,000

At Conversion (maturity date)RM1 million ICULS = # shares?New shares = 1,000,000

5= 200,000 units shares

DR ICULS 1,000,000CR Ordinary shares 200,000 CR Premium on shares

800,000