Chapter 14 - Long Term Liabilities

Question 1

Who’s approval is required for long term debts? What are the different parts included in the information of long term debts?

Answer 1

The approval of the board of directors and shareholders, which involves covenants for the protection of lenders, typically secured through non current assets.

Question 2

What is a long term liability?

Answer 2

It is an obligation arising from past transactions or events for which settlement will not take place within the next operating cycle or within a year.

Question 3

What are the three differences between debt and equity? How do we show the current portion of long term debt?

Answer 3

They have a maturity date, they bear interest and they do not have voting rights. We show it as a current asset.

Question 4

What is a bond?

Answer 4

A bond is a long term IOU, with the repayment of the sum of money at the maturity date, and periodic payments of interest until that maturity date,

Question 5

What is a bond indenture?

Answer 5

It is an agreement between the borrower and the lender.

Question 6

How do borrowers usually sell bonds?

What is an underwriter?

Answer 6

They sell it through a brokerage firm (underwriter).

An underwriter can underwrite the issue and purchase all bonds, taking on the risk of selling all the bonds to the public. In addition they can sell the issue on a best efforts basis, selling it on a consignment basis.

Question 7

What are registered bonds?

Answer 7

Allow the issuer to know the name and addresses of the bond owners.

Question 8

What are bearer bonds?

Answer 8

Are not registered bonds, but have coupons that are often attached to them, often clipped off by the owners, and presented to an institution to receive interest.

Question 9

What are unsecured bonds?

Answer 9

These are junk bonds as they have low ratings because they bear a greater amount of risk.

Question 10

What are term bonds?

Answer 10

The entire issue has a single maturity date.

Question 11

What are serial bonds?

Answer 11

Different portions of the bonds mature at different times.

Question 12

What is a redeemable/ callable bond?

Answer 12

The issuer has the right to buy back the bond prior to maturity, at a specified price or fair value.

Question 13

What is a pitiable / retractable bond?

Answer 13

The holder has the right to buy back the bond prior to maturity, at a specified price or fair value.

Question 14

What are income bonds? What are revenue bonds?

Answer 14

These are bonds where the interest payment depends on the income of the issuer. These are bonds where the interest payment depends on the revenue of the issuer.

Question 15

True or False: Bonds are convertible into preferred or common stock.

Answer 15

True.

Question 16

What are commodity based / asset linked bonds

Answer 16

Their maturity value is based on the commodity quantities.

Question 17

What are deep discount / zero interest bonds?

What is another name for zero interest bonds and why is it called this?

Answer 17

They pay very low or no interest at all, so they sell at a very low price. For the issuer, they only receive interest through the amortization of the discount of the bond overtime.’

Stripped bonds as the issuer of the bonds has removed all coupons from the bonds.

Question 18

How do different countries treat the difference between the maturity and the price paid for the bond?

Answer 18

Some treat it as a capital gains rather than interest income, which can result in lower taxes.

Question 19

Describe bond ratings. What are an example of bond rules? What is the advantage to having a high bond rating?

Answer 19

They are a series of letters ranging from AAA to CCC to determine the quality of the bonds based on historic defaults. Pension plans and university endowments have plans that only allow them to invest in BBB or higher investment grade bonds. These companies have access to more funding.

Question 20

What grade are investment grade bonds?

Answer 20

BBB and higher.

Question 21

When a company issues a bond, what are the two things they are selling?

Answer 21

1. Future lump sum payment at maturity (par value)
2. Annuity of interest payments by multiplying the par value by the coupon rate (stated)

Question 22

How is the price of a bond determined at the sale date?

Answer 22

By using the coupon rate to calculate the payment, the number of years till maturity, the maturity (par) value, and a market interest rate (yield)

Question 23

What happens when the market interest rate is higher than the stated rate?

Answer 23

It is sold at a discount, as it is less attractive to investors, as they could get better deals on the market.

Question 24

What happens when the market interest rate is lower than the stated rate?

Answer 24

It is sold at a premium, as it is more attractive to investors, as this is a better deal.

Question 25

What are the effects of changes in the market rate under the amortized cost model?

Answer 25

They are irrelevant.

Question 26

Which rate is used when determining the price and why?

Answer 26

The market interest rate is used when determining the price, and this is because that is what is relevant to the purchaser.

Question 27

Why do we amortize the bond discount over the life of the bonds term?

Answer 27

It is a form of interest expense incurred during that time. It is a penalty we recognize overtime as an increasing interest expense, thus the interest expense will be higher than the interest paid by the discount amortized.

Question 28

What happens if we have a bond premium?

Answer 28

This is a form of interest expense incurred during that time. It is a penalty we recognize over time but the expense gets lower and lower, than the interest paid by the premium amortized.

Question 29

What method can be used under IFRS vs ASPE when amortizing?

Answer 29

Under IFRS we can only amortize under the effective interest rate model. Under ASPE we can amortize under the effective interest rate model or the straight line model.

Question 30

What is the flaw with the straight line method?

Answer 30

The flaw with the straight line method is that it keeps the value the same, even though the net liability of the bond (Bond Payable - discount) os rising. If it is rising there should be higher interest each period.

Question 31

What are two things that must be done when repaying debts prior to the maturity date?

Answer 31

1. Record any amortization of the premium or discount up to the current date. 2. Record a gain or loss on the extinguishment and remove unamortized discounts or premiums relating to the redeemed bonds.

Question 32

How do we calculate proceeds when a company issues a bond late?

Answer 32

It is equivalent to the price of the bond and the interest accrued to date.

Question 33

When do we calculate interest?

Answer 33

When we have a bond at the beginning and end of a full payment period, and we are not preparing financial statements between these dates, such as selling a bond on Jan 1 that pays interest on December 31.

Question 34

What are the two ways to calculate interest expense?

Answer 34

1. To multiple the opening carrying amount in the period by the market interest rate. 2. We can calculate the change in PV which acts as the bond discount or premium. We can then add this discount / subtract this premium to determine the interest expense (plug).

Question 35

What do we do if a bond is outstanding at the beginning and end of a payment period, but we have to accrue it?

Answer 35

Calculate the interest for the entire payment period, and prorate based on the accrual.

Question 36

Why should we not calculate interest between payment dates by using the plug technique?

Answer 36

We do not want to use fractional periods, as they do not compound in these fractional periods, it only compounds in full payment periods. The interest compounds once per period, not fractional periods.

Question 37

When should the fractional N PV calculation method be used?

Answer 37

When we are issuing a bond or when we are buying it back. We must never use it when calculating the interest.

Question 38

If we sell a bond late, and are trying to calculate interest for a stub period, how do we do it?

Answer 38

Determine interest expense by plugging. We calculate the premium or discount by using a fractional N when we sold it, and when the payment period happens, providing with the discount / premium. We then know the cash payment, and to balance the entry it would be classified as the interest expense.

Question 39

What happens if the year end does not coincide with the payment date?

Answer 39

We prorate the interest expense up to the payment date.

Question 40

What are the five issue costs for the bonds?

Answer 40

1. Accounting fees 2. Commissions 3. Underwriting fees 4. Legal fees 5. Printing Costs.

Question 41

What is the typical way to deal with the issuance costs under an IFRS and ASPE situation? What is the impact of this?

Answer 41

We add these costs to the discount account. We subtract these costs from the premium account. The impact is that it changes the carrying amount, thus changes the PV calculation, and overall changes the amount of interest expense to be recorded.

Question 42

What is a way most companies deal with the costs of issuing a bond? What happens if the bond is valued at fair value?

Answer 42

They can expense it or set it up as a deferred charge asset, and amortize it over the useful life of the bond. If it is valued at fair value, than these costs are ignored and not recorded against the discount or premium.

Question 43

What are the two ways to present a bond discount?

Answer 43

They are presented as a contra account to the bonds payable account, but some companies may show it as a deferred charge on the asset side of the statement of financial position.

Question 44

How is the bond premium presented?

Answer 44

It is presented as an adjunct account to the bond payable account.

Question 45

How do we account for non-market rates of interest on marketable securities? - What is situation is this similar too? - What is the difference when we account for this? - Does the issuer need to impute an interest rate?

Answer 45

In this situation, it is similar to accounting for a bond with a discount. The only difference is that the discount will be quite large and there are no interest payments. It will be amortized over the periods, using the effective interest rate method. It depends, they mioght have too but they might also not have too.

Question 46

- What is a non market rates of interest - Non marketable loan? - Why would a zero interest notes/bond/loan not be issued at a discount? - What are examples of the consideration provided such that a zero interest bearing note is not issued at a discount?

Answer 46

A loan, bond, or note in a private arrangement, where a fair value is not present, one must be cautious with the valuation and not assume a discount immediately. -Typically if this is the case, there is often another form of consideration being provided to the issuer of the bond to the creditor. The benefit is recorded separately, and can be a reduce sales price on its products or some other form.

Question 47

How do we determine the discount on a note if it is issued for property, goods, or services, and the note does not bear interest (i.e - no stated rate) or market rate is unreasonably low? - Do we have to calculate an interest rate?

Answer 47

Take the maturity value of the note and subtract the fair value of the asset received. Depending on the circumstance, we may have to impute the interest rate in the transaction, by using a PV calculation.

Question 48

What do we do if a company receive a government loan to purchase an asset but it bears interest below market interest rates?

Answer 48

Treat the differential (premium) as a government grant.

Question 49

- Are companies alowed to value financial liabilities under fair value model under ASPE? - Why do most companies not do this?

Answer 49

-Companies have the ability to value through fair value rather than amortized cost. -However, most do not take this option as the intent of a financial liability is to hold it until the maturity date. Therefore, the fluctuations are meaningless as we will not pay the fair value when settling them in the future.

Question 50

- Are companies allowed to value financial liabilities under fair value mode under IFRS? What is the rule? - What is an example of when this would be permitted?

Answer 50

Companies are only permitted to use this if it will give the financial statement users more relevant information about the debts. This is if a company manages its debts based on fair value rather than maturity value.

Question 51

- Describe what happens if the interest rates rise under the IFRS Fair Value Model

Answer 51

1. The fall in the PV of the debt will give rise to a gain in the Statement of Income. 2. It will show a gain and lower debts even if the higher interest rates place them in a more risky position. 3. Under IFRS the company would have to show this in the OCI section.

Question 52

What is the derecognition of debt?

Answer 52

It is the extinguishment of long-term liability at or before its maturity date. We can de recognize it if it is retired prior to maturity.

Question 53

What is a sinking fund?

Answer 53

An asset representing a fund of cash set aside to extinguish the debt at some future time.

Question 54

What are the two situations where we can derecognize a debt?

Answer 54

1. Company discharges the liability by paying off the debt 2. The creditor legally releases the company from the obligation.

Question 55

What is refunding?

Answer 55

The replacement of one form of debt with another, and in some situations we account for this as extinguishment of one type of debt with a gain or loss recorded.

Question 56

How do we account for a significant modification? What does substantial mean in this context? What interest rate is used when administering this test?

Answer 56

We extinguish the old debt and we recognize a gain or loss, replaced with the new debt. . The modified debt's present value differs from the existing debt's, by at least 10%. The market rate when issuing the old debt.

Question 57

How do we value the new liability under significant modifications? What is the other side of the entry?

Answer 57

PV of the new debt using current market interest rates and the modified cash flows. The gain or loss from the settlement of the old obligation.

Question 58

How do we account for a modification that is not significant under ASPE?

Answer 58

1. Do not record a gain or loss 2. Do not adjust the carrying amount of the debt. 3. Impute a new interest rate based on the modification made.

Question 59

What does the new interest rate represent?

Answer 59

1. Makes the PV of the modified future cash flows equal the current carrying amount of the debt. 2. When we calculate an interest expense, the difference between this and the cash interest paid, will cause an adjustment to the carrying amount, which overtime make it equal to the new maturity value.

Question 60

- What is defeasance? - When does defeasance occur?

Answer 60

It is a way to extinguish debt without actually paying it off. It occurs when a company places enough funds in an irrevocable trust to pay off the interest on the issued debt and its principal at the date of maturity.

Question 61

Why would some companies want to perform defeasance?

Answer 61

1. The holders of the bonds may not want to sell the bonds because increased interest rates may have lowered the fair value of the bonds. 2. The company may not want to buy the bonds if the interest rates drop, since this increase the price of the bonds needed to buy the bond.

Question 62

What is the advantage of defeasance? What ratios does it improve? What does this result in?

Answer 62

It removes the bond from the statement of financial position improving the working capital and the debt to equity ratio, which could also result in a gain being recorded.

Question 63

What is the legal defeasance?

Answer 63

The trustee agrees to assume the legal obligations of the creditor, and take on the responsibility for the payment of principal and interest payments.

Question 64

What is in substance defeasance?

Answer 64

The creditor may not even be aware of the existence of a trust, and so legally a defeasance does not occur, and there is no settlement of the debt.

Question 65

How do we account for long term notes?

Answer 65

We account for long term notes like we would for long term bonds. It can be interest bearing or non interest bearing.

Question 66

What is off balance sheet financing?

Answer 66

It is a situation where debt exists but we do not record it on the statement of financial position.

Question 67

What are the three reasons that off sheet balancing occurs?

Answer 67

1. Non consolidated entities, the parent company has no control over these other entities. 2. Variable interest entities - Entities set up to hold the assets and debts of a company. 3. Treat a lease as an operating lease.

Question 68

What information must be presented for bonds, mortgages, debentures, and similar securities?

Answer 68

1. Title of the issue 2. Interest rate 3. Maturity date 4. Amount outstanding 5. Existence of sinking funds. 6. Redemption 7. Conversion provisions.

Question 69

What information must be disclosed regarding sinking funds or retirement provisions?

Answer 69

The aggregate value of payments that the company estimates is necessary to pay in the next five years

Question 70

How do we present long term debt obligations that could be paid within a year?

Answer 70

A current liability as long as it an be paid with the current funds.

Question 71

How do we represent a company's securities that are purchased but not cancelled?

Answer 71

It is shown as a deduction of the related liability.

Question 72

What are three other details that should be known about the presentation of long term or non-current debts?

Answer 72

1. Separately disclose secured liabilities. 2. Details of defaults such as principal, interest, sinking fund, redemption provisions. 3. Statement of income distinguish interest on indebtedness initially incurred for a term of more than one year.

Question 73

What does debt to total asset measure?

Answer 73

The extent to which a company finances its asset with debt. The higher the ratio the more debt it has, the higher the leverage.

Question 74

What is the debt to total asset ratio?

Answer 74

Total Debt / Total Assets

Question 75

What is the times interest earned ratio?

Answer 75

Measures the ability of the company to pay its own interest expense. The higher the ratio the more capable the company is.

Question 76

What is the times interest earned ratio?

Answer 76

Income before income taxes and interest expense / Interest Expense

Question 77

How do we perform a good analysis of the company's debt?

Answer 77

By analyzing both the times interest earned and debt to asset ratio. If for example the total debt to asset ratio has risen, we can classify it as successful if the time interest earned has also risen, as it means they are able to pay off their interest on the additional debt.