Intermediate Financial Accounting II

21/02/2023

Chapter Two
Non-Current Liabilities
2.1. Nature and classifications of non-current liabilities
Non-current liabilities (sometimes referred to as 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. Bonds payable, long-term notes payable, mortgages
payable, pension liabilities, and lease liabilities are examples of non-current liabilities.

A company usually requires approval by the board of directors and the shareholders before bonds
or notes can be issued. The same holds true for other types of long-term debt arrangements.
Generally, long-term debt has various covenants or restrictions that protect both lenders and
borrowers. The indenture or agreement often includes the amounts authorized to be issued,
interest rate, due date(s), call provisions, property pledged as security, sinking fund
requirements, working capital and dividend restrictions, and limitations concerning the
assumption of additional debt.

Companies should describe these features in the body of the financial statements or the notes, if
important for a complete understanding of the financial position and the results of operations.
Although it would seem that these covenants provide adequate protection to the long-term debt
holder, many bondholders suffer considerable losses when companies add more debt to the
capital structure. Consider what can happen to bondholders in leveraged buyouts (LBOs), which
are usually led by management.

2.1.1. Bonds Payable

A. Types of Bonds
 Secured and Unsecured Bonds: Secured bonds are backed by a pledge of some sort of
collateral. Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are
secured by shares and bonds of other companies. Bonds not backed by collateral are
unsecured. A debenture bond is unsecured. A “junk bond” is unsecured and also very risky,
and therefore pays a high interest rate. Companies often use these bonds to finance leveraged
buyouts.

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 Term, Serial Bonds, and Callable Bonds: Bond issues that mature on a single date are
called term bonds; issues that mature in installments are called serial bonds. Serially
maturing bonds are frequently used by school or sanitation districts, municipalities, or other
local taxing bodies that receive money through a special levy. Callable bonds give the issuer
the right to call and retire the bonds prior to maturity.
 Convertible Bonds: If bonds are convertible into other securities of the company for a
specified time after issuance, they are convertible bonds. Two types of bonds have been
developed in an attempt to attract capital in a tight money market —commodity-backed
bonds and deep-discount bonds. Commodity-backed bonds (also called asset-linked bonds)
are redeemable in measures of a commodity, such as barrels of oil, tons of coal, or ounces of
rare metal. To illustrate, Sunshine Mining (USA), a silver-mining company, sold bonds that
were redeemable with either $1,000 in cash or 50 ounces of silver, whichever was greater at
maturity, and that had a stated interest rate of 8½ percent. The accounting problem was one
of projecting the maturity value, especially since silver has fluctuated between $4 and $40 an
ounce since issuance.
 Deep-discount bonds: also referred to as zero-interest debenture bonds, are sold at a
discount that provides the buyer’s total interest payoff at maturity, with no periodic interest
payments.
 Registered and Bearer (Coupon) Bonds: Bonds issued in the name of the owner are
registered bonds and require surrender of the certificate and issuance of a new certificate to
complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner
and may be transferred from one owner to another by mere delivery.
 Income and Revenue Bonds: Income bonds pay no interest unless the issuing company is
profitable. Revenue bonds, so called because the interest on them is paid from specified
revenue sources, are most frequently issued by airports, school districts, counties, toll-road
authorities, and governmental bodies.
2.1.2. Issuing Bonds
A bond arises from a contract known as a bond indenture. A bond represents a promise to pay (1)
a sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on the
maturity amount (face value). Individual bonds are evidenced by a paper certificate and typically
have a €1,000 face value. Companies usually make bond interest payments semiannually,

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although the interest rate is generally expressed as an annual rate. The main purpose of bonds is
to borrow for the long term when the amount of capital needed is too large for one lender to
supply. By issuing bonds in €100, €1,000, or €10,000 denominations, a company can divide a
large amount of long-term indebtedness into many small investing units, thus enabling more than
one lender to participate in the loan.

A company may sell an entire bond issue to an investment bank, which acts as a selling agent in
the process of marketing the bonds. In such arrangements, investment banks could underwrite
the entire issue by guaranteeing a certain sum to the company, thus taking the risk of selling the
bonds for whatever price they can get (firm underwriting). Or, the underwriters could sell the
bond issue for a commission on the proceeds of the sale (best-efforts underwriting).
Alternatively, the issuing company could sell the bonds directly to a large institution, financial or
otherwise, without the aid of an underwriter (private placement).

Valuation and Accounting for Bonds Payable

The issuance and marketing of bonds to the public does not happen overnight. It usually takes
weeks or even months. First, the issuing company must arrange for underwriters which will help
market and sell the bonds. Then, it must obtain regulatory approval of the bond issue, undergo
audits, and issue a prospectus (a document that describes the features of the bond and related
financial information).

Finally, the company must generally have the bond certificates printed. Frequently, the issuing
company establishes the terms of a bond indenture well in advance of the sale of the bonds.
Between the time the company sets these terms and the time it issues the bonds, the market
conditions and the financial position of the issuing company may change significantly. Such
changes affect the marketability of the bonds and thus their selling price.

The selling price of a bond issue is set by the supply and demand of buyers and sellers, relative
risk, market conditions, and the state of the economy. The investment community values a bond
at the present value of its expected future cash flows, which consist of (1) interest and (2)
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 often printed on

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the bond certificate) is known as the stated, coupon, or nominal rate. The issuer of the bonds sets
this rate. The stated rate is expressed as a percentage of the face value of the bonds (also called
the par value, principal amount, or maturity value).

Bonds Issued at Par

If the rate employed by the investment community (buyers) is the same as the stated rate, the
bond sells at par. That is, the par value equals the present value of the bonds computed by the
buyers (and the current purchase price). To illustrate the computation of the present value of a
bond issue, assume that Santos SA issues R$100,000 in bonds dated January 1, 2022, 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.
Illustration 2.1 depicts both the interest and the principal cash flows.

Illustration 2.2 Present Value Computation of Bond Selling at Par

By paying R$100,000 (the par value) at the date of issue, investors realize an effective rate or
yield of 9 percent over the five-year term of the bonds. Santos makes the following entries in the
first year of the bond.

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Bonds Issued at Discount or Premium

If the rate employed by the investment community (buyers) differs from the stated rate, the
present value of the bonds computed by the buyers (and the current purchase price) will differ
from the face value of the bonds. The difference between the face value and the present value of
the bonds determines the actual price that buyers pay for the bonds. This difference is either a
discount or premium.
 If the bonds sell for less than face value, they sell at a discount.
 If the bonds sell for more than face value, they sell at a premium.
The rate of interest actually earned by the bondholders is called the effective yield or market
rate.
If bonds sell at a discount, the effective yield exceeds the stated rate. Conversely, if bonds sell at
a premium, the effective yield is lower than the stated rate. Several variables affect the bond’s
price while it is outstanding, most notably the market rate of interest. There is an inverse
relationship between the market interest rate and the price of the bond.
To illustrate, assume 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.
Illustration 2.3 depicts both the interest and the principal cash flows.

Effective-Interest Method
As discussed earlier, by paying more or less at issuance, investors earn a rate different than the
coupon rate on the bond. Recall that the issuing company pays the contractual interest rate over
the term of the bonds but also must pay the face value at maturity. If the bond is issued at a
discount, the amount paid at maturity is more than the issue amount. If issued at a premium, the
company pays less at maturity relative to the issue price.

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The company records this adjustment to the cost as bond interest expense over the life of the
bonds through a process called amortization. Amortization of a discount increases bond interest
expense. Amortization of a premium decreases bond interest expense.
The required procedure for amortization of a discount or premium is the effective-interest
method (also called present value amortization). Under the effective-interest method, companies:
o Compute bond interest expense first by multiplying the carrying value (book value) of the
bonds at the beginning of the period by the effective-interest rate.
o Determine the bond discount or premium amortization next by comparing the bond
interest expense with the interest (cash) to be paid.
Illustration 2.4 depicts graphically the computation of the amortization.

Bonds Issued at a Discount

To illustrate amortization of a discount under the effective-interest method, assume Ever master
AG issued €100,000 of 8 percent term bonds on January 1, 2022, due on January 1, 2027, with
interest payable each July 1 and January 1. Because the investors required an effective-interest
rate of 10 percent, they paid €92,278 for the €100,000 of bonds, creating a €7,722 discount. Ever
master computes the €7,722 discount as shown in Illustration 2.5

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Bonds Issued at a Premium

Now assume that for the bond issue described above, investors are willing to accept an effective
interest rate of 6 percent. In that case, they would pay €108,530 or a premium of €8,530,
computed as shown in Illustration 2.6.

2.2. Long-Term Notes Payable

Accounting for notes and bonds is quite similar. Like a bond, a note is valued at the present value
of its future interest and principal cash flows. The company amortizes any discount or premium
over the life of the note, just as it would the discount or premium on a bond. Companies compute
the present value of an interest-bearing note, record its issuance, and amortize any discount or
premium and accrual of interest in the same way that they do for bonds.
Zero-Interest-Bearing Notes
If a company issues a zero-interest-bearing (non-interest-bearing) note7 solely for cash, it
measures the note’s present value by the cash received. The implicit interest rate is the rate that
equates the cash received with the amounts to be paid in the future. The 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.
Interest-Bearing Notes
The zero-interest-bearing note above is an example of the extreme difference between the stated
rate and the effective rate. In many cases, the difference between these rates is not so great.
2.3. Special Notes Payable Situations
Notes Issued for Property, Goods, or Services
Sometimes, companies may receive property, goods, or services in exchange for a note payable.
When exchanging the debt instrument for property, goods, or services 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
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2. The stated interest rate is unreasonable, or

3. The stated face amount of the debt instrument is materially different from the current
cash sales price for the same or similar items or from the current fair value of the debt
instrument.
In these circumstances, the company measures the present value of the debt instrument by the
fair value of the property, goods, or services or by an amount that reasonably approximates the
fair value of the note. If there is no stated rate of interest, the amount of interest is the difference
between the face amount of the note and the fair value of the property.
Choice of Interest Rate
In note transactions, the effective or market interest rate is either evident or determinable by
other factors involved in the exchange, such as the fair value of what is given or received. But, if
a company cannot determine the fair value of the property, goods, services, or other rights, and if
the note has no ready market, determining the present value of the note is more difficult. To
estimate the present value of a note under such circumstances, a company must approximate an
applicable interest rate that may differ from the stated interest rate. This process of interest-rate
approximation is called imputation, and the resulting interest rate is called an imputed interest
rate.
The prevailing rates for similar instruments of issuers with similar credit ratings affect the choice
of a rate. Other factors, such as restrictive covenants, collateral, payment schedule, and the
existing prime interest rate, also play a part. Companies determine the imputed interest rate when
they issue a note; any subsequent changes in prevailing interest rates are ignored.
Mortgage Notes Payable
A common form of long-term notes payable is a mortgage note payable. A mortgage note
payable is a promissory note secured by a document called a mortgage that pledges title to
property as security for the loan. Individuals, proprietorships, and partnerships use mortgage
notes payable more frequently than do larger companies (which usually find that bond issues
offer advantages in obtaining large loans).
The borrower usually receives cash for the face amount of the mortgage note. In that case, the
face amount of the note is the true liability, and no discount or premium is involved. When the
lender assesses “points,” however, the total amount received by the borrower is less than the face

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amount of the note. Points raise the effective-interest rate above the rate specified in the note. A
point is 1 percent of the face of the note.
2.4. Extinguishment of Non-Current Liabilities
In this section, we discuss extinguishment of debt under three common additional situations:
1. Extinguishment with cash before maturity.
2. Extinguishment by transferring assets or securities.
3. Extinguishment with modification of terms.
Extinguishment with Cash before Maturity
In some cases, a company extinguishes debt before its maturity date. The amount paid on
extinguishment or redemption before maturity, including any call premium and expense of
reacquisition, is called the reacquisition price. On any specified date, the carrying amount of the
bonds is the amount payable at maturity, adjusted for unamortized premium or discount. Any
excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The
excess of the reacquisition price over the carrying amount is a loss from extinguishment. At the
time of reacquisition, the unamortized premium or discount must be amortized up to the
reacquisition date.

Note that it is often advantageous for the issuer to acquire the entire outstanding bond issue and
replace it with a new bond issue bearing a lower rate of interest. The replacement of an existing
issuance with a new one is called refunding. Whether the early redemption or other
extinguishment of outstanding bonds is a non-refunding or a refunding situation, a company
should recognize the difference (gain or loss) between the reacquisition price and the carrying
amount of the redeemed bonds in income (in other income and expenses) of the period of
redemption.
Extinguishment by Exchanging Assets or Securities
In addition to using cash, settling a debt obligation can involve either a transfer of non-cash
assets (real estate, receivables, or other assets) or the issuance of the debtor’s shares. In these
situations, the creditor should account for the non-cash assets or equity interest received at their
fair value.
The debtor must determine the excess of the carrying amount of the payable over the fair value
of the assets or equity transferred (gain). The debtor recognizes a gain equal to the amount of the

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excess. 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).
Transfer of Assets
Assume that 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 real estate with a fair
value of €16,000,000 from Bonn Mortgage 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.

Bonn Mortgage has a loss on the disposition of real estate in the amount of €5,000,000 (the
difference between the €21,000,000 book value and the €16,000,000 fair value). In addition, it
has a gain on settlement of debt of €4,000,000 (the difference between the €20,000,000 carrying
amount of the note payable and the €16,000,000 fair value of the real estate).
Granting of Equity Interest
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.

It records the ordinary shares issued in the normal manner. It records the difference between the
par value and the fair value of the shares as share premium.

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Extinguishment with Modification of Terms

Practically every day, the Wall Street Journal or the Financial Times runs a story about some
company in financial difficulty, such as Japan Display (JPN) or Bayer AG (DEU). In many of
these situations, a creditor may grant a borrower concessions with respect to settlement. The
creditor offers these concessions to ensure the highest possible collection on the loan. For
example, a 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.
As with other extinguishments, when a creditor grants favorable concessions on the terms of a
loan, the debtor has an economic gain. Thus, the accounting for modifications is similar to that
for other extinguishments. That is, the original obligation is extinguished, the new payable is
recorded at fair value, and a gain is recognized for the difference in the fair value of the new
obligation and the carrying value of the old obligation.

To illustrate, assume that on December 31, 2022, Morgan National Bank enters into a debt
modification agreement with Resorts Development Group, which is experiencing financial
difficulties. 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, 2022, to December 31, 2026; 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.

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