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Understanding Debt Instruments

Objective 1
Understand the nature of long-term debt financing arrangements.
Long-term debt consists of obligations that are not payable within a year or the operating cycle of the business,
whichever is longer, and will therefore require probable sacrifices of economic benefits in the future. Bonds payable,
long-term notes payable, mortgages payable, pension liabilities, and lease liabilities are examples of long-term debt
or liabilities.1
The process that leads to incurring long-term debt is often very formal. For example, the bylaws of corporations
usually require that the board of directors and the shareholders give their approval before bonds can be issued or
other long-term debt arrangements can be contracted. When companies arrange for financing, the details of the
arrangements are generally documented in legal contracts. The contracts determine the rights and obligations of the
lender and borrower and state the terms of the arrangement, including the interest rate, the due date or dates, call
provisions, property pledged as security, and sinking fund requirements.
The contracts may also include restrictive covenants (terms or conditions) that are meant to limit activities and
protect both lenders and borrowers. Examples of these types of covenants include working capital and dividend
restrictions, and limitations on incurring additional debt. Covenants to restrict the amount of additional debt are
common. Additional debt increases the risk of insolvency and there is a limit to the amount of risk that creditors are

willing to accept even though some lenders can tolerate more risk than others.
Bonds and Notes Payable

Bonds are the most common type of long-term debt that companies report on their statements of financial
position.

Characteristics
The main purpose of bonds is to borrow for the long term when the amount of capital that is needed is too large for
one lender to supply. When bonds are issued in $100, $1,000, or $10,000 denominations, a large amount of long-
term indebtedness can be divided into many small investing units, which makes it possible for more than one lender
to participate in the loan.
A bond is created by a contract known as a bond indenture and represents a promise to pay both of the following:
(1) a sum of money at a designated maturity date, and (2) periodic interest at a specified rate on the maturity amount
(face value). Individual bonds are evidenced or supported by a paper certificate and they typically have a $1,000
face value. Bond interest payments are usually made semi-annually, but the interest rate is generally expressed as an
annual rate.
An entire bond issue may be sold to an investment banker who acts as a selling agent and markets the
bonds. In such arrangements, investment bankers may do one of two things. They may underwrite the
entire issue by guaranteeing a certain sum to the corporation, thus taking the risk of selling the bonds
for whatever price the agent can get (which is known as firm underwriting). They may instead sell
the bond issue for a commission that will be deducted from the proceeds of the sale (which is known
as best efforts underwriting). Alternatively, the issuing company may choose to place a bond issue
privately by selling the bonds directly to a large institution—which may or may not be a financial
institution—without the aid of an underwriter. This situation is known as private placement.
The difference between current notes payable and long-term notes payable is the maturity date. As discussed in
Chapter 13, short-term notes payable are expected to be paid within a year or the operating cycle, whichever is
longer. Long-term notes are similar in substance to bonds in that both have fixed maturity dates and carry either a
stated or implicit interest rate. However, notes do not trade as easily as bonds in the organized public securities
markets, and sometimes do not trade at all.
Even though the legal form of a note is different from a bond, the economic substance is the same because they both
represent liabilities. They therefore receive substantially the same treatment from an accounting perspective,
depending on the features that the specific note or bond carries.

Types
The following are some of the more common types of long-term debt that are found in practice. Each
type of instrument has specific contractual features that manage risk for the company and/or the
holder. For instance, a secured bond is less risky and therefore often has a lower rate of interest. Any
feature that gives the holder more choice or options is generally more desirable to the investor, who
may be willing to pay a premium for the flexibility. Where the company has choices and options,
such as an option to convert the bond into shares, this may be seen as less desirable by the investors
because the choices and options are beyond their control. Each feature noted below changes the
riskiness and desirability of the instruments and therefore affects the pricing of the instrument. Note
that debt may be denominated in a foreign currency. This means that the interest and principal
repayments must be paid using foreign currency.
Registered and Bearer (Coupon) Bonds
Bonds that are issued in the owner's name are called registered bonds. To sell a registered bond, the current
certificate has to be surrendered and a new certificate is then issued. A bearer or coupon bond, however, is not
recorded in the owner's name and may therefore be transferred from one owner to another by simply delivering it to
the new owner.

Because the various features of debt instruments alter the risk profile, the full disclosure principle would support
disclosing specific information about these features.

Secured and Unsecured Debt


Secured debt is backed by a pledge of some sort of collateral. Mortgage bonds or notes are secured by a claim on
real estate. Collateral trust bonds or notes are secured by shares and bonds of other corporations. Debt instruments
that are not backed by collateral are unsecured; for example, debenture bonds. Junk bondsare unsecured and also
very risky, and therefore pay a high interest rate. These bonds are often used to finance leveraged buyouts.
Term, Serial, and Perpetual Bonds or Notes
Debt issues that mature on a single date are called term bonds or notes, and issues that mature in instalments are
called serial bonds or notes. Serial bonds are frequently used by schools, municipalities, and provincial or federal
governments. Perpetual bonds or notes have unusually long terms; that is, 100 years or more, or no maturity date.
These are often referred to as century or millennium bonds, depending on the length of the term.
Income, Revenue, and Deep Discount Bonds
Income bonds pay no interest unless the issuing company is profitable. Revenue bonds have this name because the
interest on them is paid from a specified revenue source. Deep discount bonds or notes—which are also referred to
as zero-interest debentures, bonds, or notes—have very little or no interest each year and therefore are sold at a
large discount that basically provides the buyer with a total interest payoff (at market rates) at maturity.
Commodity-Backed Bonds
Commodity-backed debt, also called asset-linked debt, is redeemable in amounts of a commodity, such as barrels
of oil, tonnes of coal, or ounces of rare metal.
Callable Bonds and Notes and Convertible Debt with Various Settlement and Other
Options
Callable bonds and notes give the issuer the right to call and retire the debt before maturity. (These
are sometimes referred to as demand loans.) Convertible debtallows the holder or the issuer to
convert the debt into other securities such as common shares. Certain bonds or other financial
instruments give the issuer the option to repay or settle the principal in either cash or common
shares, or give the right to decide to the holder.

One of the more interesting innovations in the bond market is bonds whose interest or principal
payments are tied to changes in the weather. The incidence of unusual and extreme weather events has
been increasing, along with potential losses from these often unexpected events. Many insurers are
feeling the impact of this in terms of profits. The Office of the Superintendent of Financial Institutions,
the regulatory body in Canada for financial institutions including insurance companies, has signalled
that it is open to allowing insurance companies to issue these weather bonds to help manage risk.

Holders of the bonds would lose their rights to some or all of the interest and/or principal payments if a “triggering
event” occurred. A triggering event could be anything from an excess amount of rainfall to a hailstorm or drought.
Why would an investor buy this type of security? The instrument would have to be priced to compensate for the
riskiness of the instrument by offering a higher interest return or being sold at a discount.
These instruments are part of a larger group of instruments sometimes referred to as catastrophe bonds (“cat”
bonds), which are used globally. The bonds are often sold in private placement offerings, meaning that they are sold
to large institutional investors. Because many bonds do not repay the principal if the triggering event occurs, they
are referred to as “principal-at-risk variable-rate notes.”

Credit Ratings
A credit rating is assigned to each new public bond issue by independent credit rating agencies. This rating
reflects a current assessment of the company's ability to pay the amounts that will be due on that specific
borrowing. The rating may be changed up or down during the issue's outstanding life because the quality is
constantly monitored. Note that institutional investors, such as insurance companies and pension funds, invest
heavily in investment grade securities. Investment grade securities are high-quality securities (not
speculative) and therefore only certain securities qualify. There is pressure on a company to ensure that its
debt instruments are rated investment grade so that it can have greater access to capital. Credit rating analysts
review many business models and industry factors when they make their determinations. Trends in costs and
revenues are especially important.

Two major companies, Moody's Investors Service and Standard & Poor's Corporation, issue quality
ratings on every public debt issue. The following graph shows the categories of ratings issued by Standard &
Poor's, along with historical default rates on bonds receiving these ratings. 2 As expected, bonds receiving the
highest quality rating of AAA have the lowest historical default rates. Bonds rated below BBB, which are

considered below investment grade (“junk bonds”), experience very high default rates. The next chart

shows default rates by industry.


Debt ratings reflect credit quality. The market closely monitors these ratings when determining the required
yield and pricing of bonds at issuance and in periods after issuance, especially if a bond's rating is upgraded
or downgraded. It is not surprising, then, that bond investors and companies that issue bonds keep a close
watch on debt ratings, both when bonds are issued and while the bonds are outstanding.

Defeasance
Occasionally, a company may want to extinguish or pay off debt before its due date, but economic factors,
such as early repayment penalties, may stop it from doing so. One option is to set aside the money in a trust
or other arrangement and allow the trust to repay the original debt (principal and interest) as it becomes due
according to the original agreement. To do this, the company must set aside sufficient funds so that the
investment and any return will be enough to pay the principal and interest directly to the creditor. This is
known as defeasance. If the creditor of the original debt agrees to look to the trust for repayment and give

up its claim on the company, this is known as legal defeasance.


In this case, the trust becomes the debtor and the creditor looks to the trust for payment because the company no
longer has a contractual obligation under the original loan agreement. A new legal agreement would be agreed to by
all parties stating that the principal and interest payments would be made by the trust. Accounting for defeasance is
discussed further below.

Types of Companies that Have Significant Debt Financing

As noted in earlier chapters, the business model involves obtaining financing to invest in assets that
are then used to produce income. Financing is generally obtained through three sources:
 1.Borrowing
 2.Issuing equity (shares)
 3.Using internally generated funds

There are advantages and disadvantages to using each of the above-noted sources of financing. Borrowed funds
must be repaid and therefore increase liquidity and solvency risk. However, on the positive side, borrowed funds (if
invested properly) can increase profits. This is known as leverage: the practice of using other people's money to
maximize returns to shareholders. As long as the interest paid on debt financing is less than the return earned when
the funds are invested, the excess is profit.
Issuing shares does not affect liquidity or solvency because share capital does not need to be repaid
and dividends are not mandatory (unless specified by the terms of the share). However, issuing
shares may result in dilution of ownership. Using internally generated funds is fine as long as the
company's business model is producing excess funds and as long as the company makes an
assessment regarding other potential uses for the funds. In other words, the company must ask itself
whether this is the best use of funds or whether they should be used for other things, such as to pay
down debt or pay dividends to shareholders.
Certain industries have a greater ability to borrow funds. These include capital-intensive industries (those with
significant tangible assets), such as transportation and hotel companies. Lenders are able to structure the lending
agreements in such a way as to secure the loans with the underlying tangible assets. For instance, Canadian Pacific
Railway Limited, a hotel and railway transportation company, has a long-term debt to equity ratio of 1.71:1 based
on its 2014 financial statements. Trimac Transportation Ltd., a trucking company, has a long-term debt to equity
ratio of 2.47:1 based on its 2014 financial statements.
Information for Decision-Making
Companies must manage their cash flows and borrowings to ensure that there are enough funds to continue to
operate and to maximize profits and benefit from opportunities. Continued access to low-cost funds is important. For
this reason, the amount of long-term debt financing is an important ratio. Too little long-term debt financing means
the company is not taking advantage of leverage. Too much means the company may be over extended. This could
result in higher costs of capital, and possibly the inability to access additional debt financing should the need arise.
For all these reasons, financial ratios that focus on liquidity and debt are monitored. These include ratios such as
current ratio, debt to equity, debt to total assets, and times interest earned.

Measurement
Objective 2
Understand how long-term debt is measured and accounted for.
When issued, bonds and notes are valued at the present value of their future interest and principal cash flows
(generally representing fair value). The initial carrying value is adjusted by any directly attributable issue costs. 3

Refer back to Chapters 2 and 3 for a discussion of fair values.

Bonds and Notes Issued at Par


When bonds are issued on an interest payment date at par (that is, at face value), no interest has accrued and there is
no premium or discount. The accounting entry is made simply for the cash proceeds and the bonds' face value. To
illustrate, assume that a company plans to issue 10-year term bonds with a par value of $800,000, dated January 1,
2017, and bearing interest at an annual rate of 10% payable semi-annually on January 1 and July 1. If the company
decides to issue the bonds on January 1 at par, the entry on its books would be as follows:

Cash 800,000
Bonds Payable 800,000
A=L+SE+800,000+800,000
Cash flows: ↑ 800,000 inflow
The entry to record the first semi-annual interest payment of $40,000 ($800,000×0.10×12) on July
1, 2017, would be:
Interest Expense 40,000
Cash 40,000
A=L+SE−40,000−40,000
Cash flows: ↓ 40,000 outflow
The entry to record accrued interest expense at December 31, 2017 (the year end), would be:

Interest Expense 40,000


Interest Payable 40,000
A=L+SE+40,000−40,000
Cash flows: No effect
Similarly, in Chapter 7, we discussed the recognition of a $10,000, three-year note issued at face value by
Scandinavian Imports to Bigelow Corp. In this transaction, the stated rate and the effective rate were both 10%. The
time diagram and present value calculation in Chapter 7 for Bigelow Corp. would be the same for the issuer of the
note, Scandinavian Imports, in recognizing the note payable. Because the note's present value and its face value are
the same ($10,000), no premium or discount is recognized. The issuance of the note is recorded by Scandinavian
Imports as follows:

Cash 10,000
Notes Payable 10,000
A=L+SE+10,000+10,000
Cash flows: ↑ 10,000 inflow

Discounts and Premiums


The issuance and marketing of bonds to the public does not happen overnight. It usually takes weeks
or even months. Underwriters must be arranged, the approval of the relevant securities commission
must be obtained, audits and the issuance of a prospectus may be required, and certificates must be
printed. Frequently, the terms in a bond indenture are decided well in advance of the bond sale.
Between the time the terms are set and the time the bonds are issued, the market conditions and the
issuing corporation's financial position may change significantly. Such changes affect the bonds'
marketability and, thus, their selling price.
A bond's selling price 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 future cash flows, which
consist of (1) interest and (2) principal. The rate that is used to calculate the present value of these cash flows is the
interest rate that would give an acceptable return on an investment that matches the issuer's risk characteristics.
The interest rate that is written in the terms of the bond indenture (and is ordinarily printed on the bond
certificate) is known as the stated, coupon, or nominal rate. This rate, which is set by the bond issuer, is
expressed as a percentage of the bond's face value, also called the par value, principal amount,
or maturity value. If the rate that is required by the investment community (the buyers) is different from
the stated rate, when buyers calculate the bond's present value, the result will be different from the bond's
face value, and its purchase price will therefore also differ. The difference between the bond's face value
and its present value is either a discount or premium.4 If the bonds sell for less than their face value, they
are being sold at a discount. If the bonds sell for more than their face value, they are being sold at a
premium.
The interest rate that is actually earned by the bondholders is called the effective yield or market rate. If bonds sell
at a discount, the effective yield is higher than the stated rate. Conversely, if bonds sell at a premium, the effective
yield is lower than the stated rate. While the bond is outstanding, its price is affected by several variables, but
especially by the market rate of interest. There is an inverse relationship between the market interest rate and the
bond price. That is, when interest rates increase, the bond's price decreases, and vice versa.
To illustrate the calculation of the present value of a bond issue, assume that Discount Limited issues $100,000 in
bonds that are due in five years and pay 9% interest annually at year end. At the time of issue, the market rate for
such bonds is 11%. Illustration 14-1 shows both the interest and the principal cash flows.

Illustration 14-1 Present Value Calculation of Bond Selling at a Discount


The actual principal and interest cash flows are discounted at an 11% rate for five periods as follows:

Present value of the principal: $100,000 × 0.59345 $59,345


Present value of the interest payments: $9,000 × 3.69590 33,263
Present value (selling price) of the bonds $92,608
By paying $92,608 at the date of issue, the investors will realize an effective rate or yield of 11% over the five-year
term of the bonds. These bonds would therefore sell at a discount of $7,392 ($100,000 − $92,608). Note that the
price at which the bonds sell is typically stated as a percentage of their face or par value. For example, we would say
that the Discount Limited bonds sold for 92.6 (92.6% of par). If Discount Limited had received $102,000, we would
say the bonds sold for 102 (102% of par).
When bonds sell below their face value, it means that investors are demanding a rate of interest that is higher than
the stated rate. The investors are not satisfied with the stated rate because they can earn a greater rate on alternative
investments of equal risk. Because they cannot change the stated rate, they therefore refuse to pay face value for the
bonds and instead achieve the effective rate of interest that they require by lowering the amount invested in the
bonds. The result is that the investors receive interest at the stated rate calculated on the face value, but they are
essentially earning an effective rate that is higher than the stated rate because they paid less than face value for the
bonds. Although notes do not trade as readily as bonds in stock markets, the same issues arise where the stated rate
on the notes is different from the market rate at the date of issuance.
Most long-term debt is subsequently measured at amortized cost. Under this method, the interest is adjusted for any
premium or discount over the life of the bond.

Straight-Line Method
The straight-line method is valued for its simplicity. It might be used by companies whose financial
statements are not constrained by GAAP or by companies following ASPE that choose the straight-line
method as part of their accounting policy.5

If the $800,000 of bonds illustrated earlier were issued on January 1, 2017, at 97 (97% of par), the issuance would
be recorded as follows:

Cash ($800,000 × 0.97) 776,000


Bonds Payable 776,000
A=L+SE+776,000+776,000
Cash flows: ↑ 776,000 inflow
Because of its relationship to interest, discussed above, the discount is amortized and charged to interest expense
over the period of time that the bonds are outstanding.
Under the straight-line method, the amount that is amortized each year is constant. For example, using the bond
discount above of $24,000, the amount amortized to interest expense each year for 10 years is $2,400 ($24,000 ÷ 10
years) and, if amortization is recorded annually, it is recorded as follows:

Interest Expense 2,400


Bonds Payable 2,400
A=L+SE+2,400−2,400
Cash flows: No effect
At the end of the first year, 2017, as a result of the amortization entry above, the unamortized balance of the
discount is $21,600 ($24,000 − $2,400).
If the bonds were dated and sold on October 1, 2017, and if the corporation's fiscal year ended on December 31, the
discount amortized during 2017 would be only 312 of 110 of $24,000, or $600. Three months of accrued interest
must also be recorded on December 31.
A premium on bonds payable is accounted for in much the same way as a discount on bonds payable. If the
$800,000 of par value, 10-year bonds are dated and sold on January 1, 2017, at 103, the following entry is made to
record the issuance:

Cash ($800,000 × 1.03) 824,000


Bonds Payable 824,000
A=L+SE+824,000+824,000
Cash flows: ↑ 824,000 inflow
At the end of 2017 and for each year that the bonds are outstanding, the entry to amortize the premium on a straight-
line basis is:

Bonds Payable 2,400


Interest Expense 2,400
A=L+SE−2,400+2,400
Cash flows: No effect
Bond interest expense is increased by amortizing a discount and decreased by amortizing a premium. Amortization
of a discount or premium under the effective interest method is discussed later in this chapter.
Some bonds are callable by the issuer after a certain date and at a stated price so that the issuing corporation may
have the opportunity to reduce its debt or take advantage of lower interest rates. Whether or not the bond is callable,
any premium or discount must be amortized over the bond's life up to the maturity date because it is not certain that
the issuer will call the bond and redeem it early.
Bond interest payments are usually made semi-annually on dates that are specified in the bond indenture. When
bonds are issued between interest payment dates, bond buyers will pay the seller the interest that has accrued from
the last interest payment date to the date of issue. By paying the accrued interest, the purchasers of the bonds are, in
effect, paying the bond issuer in advance for the portion of the full six-month interest payment that the purchasers
are not entitled to (but will receive) because they have not held the bonds during the entire six-month period. The
purchasers will receive the full six-month interest payment on the next semi-annual interest payment date.
To illustrate, assume that $800,000 of par value, 10-year bonds, dated January 1, 2017 and bearing interest at an
annual rate of 10% payable semi-annually on January 1 and July 1, are issued on March 1, 2017 at par plus accrued
interest. The entry on the books of the issuing corporation is:

Cash 813,333
Bonds Payable 800,000
Interest Expense ($800,000×0.10×212) 13,333a
A=L+SE+813,333+800,000+13,333
Cash flows: ↑ 813,333 inflow
The purchaser is thus advancing two months of interest because on July 1, 2017, four months after the date of
purchase, the purchaser will receive six months of interest from the issuing company. The issuing company makes
the following entry on July 1, 2017:

Interest Expense 40,000


Cash 40,000
A=L+SE−40,000−40,000
Cash flows: ↓ 40,000 outflow
The expense account now contains a debit balance of $26,667, which represents the proper amount of interest
expense: four months at 10% on $800,000.
The above illustration was simplified by having the January 1, 2017 bonds issued on March 1, 2017 at par. If,
however, the 10% bonds were issued at 102, the entry on March 1 on the issuing corporation's books would be:

Cash [($800,000×1.02)+($800,000×0.10×212)] 829,333


Bonds Payable 816,000
Interest Expense 13,333
A=L+SE+829,333+816,000+13,333
Cash flows: ↑ 829,333 inflow
The premium would be amortized from the date of sale, March 1, 2017, not from the date of the bonds, January 1,
2017.
Effective Interest Method
A common method for amortizing a discount or premium is the effective interest method. This method is required
under IFRS and allowed as an accounting policy choice under ASPE. Under the effective interest method, the steps
are as follows:
 1.Interest expense is calculated first by multiplying the carrying value6 of the bonds or notes at the beginning
of the period by the effective interest rate.
 2.The discount or premium amortization is then determined by comparing the interest expense with the interest
to be paid.
Illustration 14-2 shows the formula for calculating the amortization under this method.

Illustration 14-2 Bond Discount and Premium Amortization Calculation


The effective interest method produces a periodic interest expense that is equal to a constant percentage of the
bonds' or notes' carrying value.
Both the effective interest and straight-line methods result in the same total amount of interest expense over the term
of the bonds.

Example: Bonds Issued at a Discount


To illustrate the amortization of a discount using the effective interest method, assume that Master Corporation
issued $100,000 of 8% term bonds on January 1, 2017 that are due on January 1, 2022, with interest payable each
July 1 and January 1. Because the investors required an effective interest rate of 10%, they paid $92,278 for the
$100,000 of bonds, creating a $7,722 discount. The $7,722 discount is calculated as in Illustration 14-3.7
Maturity of bonds payable $100,000
Present value of $100,000 due in 5 years at 10%, interest payable semi-annually ($100,000 ×
$61,391
0.61391)
Present value of $4,000 interest payable semi-annually for 5 years at 10% annually ($4,000 ×
30,887
7.72173)
Proceeds from sale of bonds 92,278
Discount on bonds payable $ 7,722
Illustration 14-3 Calculation of Discount on Bonds Payable
The five-year amortization schedule appears in Illustration 14-4.
SCHEDULE OF BOND DISCOUNT AMORTIZATION
Effective Interest Method—Semi-Annual Interest Payments
5-Year, 8% Bonds Sold to Yield 10%

Date Cash Paid Interest Expense Discount Amortized Carrying Amount of Bonds
1/1/17 $ 92,278
7/1/17 $ 4,000a $ 4,614b $ 614c 92,892d
1/1/18 4,000 4,645 645 93,537
7/1/18 4,000 4,677 677 94,214
1/1/19 4,000 4,711 711 94,925
7/1/19 4,000 4,746 746 95,671
SCHEDULE OF BOND DISCOUNT AMORTIZATION
Effective Interest Method—Semi-Annual Interest Payments
5-Year, 8% Bonds Sold to Yield 10%

Date Cash Paid Interest Expense Discount Amortized Carrying Amount of Bonds
1/1/20 4,000 4,783 783 96,454
7/1/20 4,000 4,823 823 97,277
1/1/21 4,000 4,864 864 98,141
7/1/21 4,000 4,907 907 99,048
1/1/22 4,000 4,952 952 100,000
$40,000 $47,722 $7,722
Illustration 14-4 Bond Discount Amortization Schedule
The entry to record the issuance of Master Corporation's bonds at a discount on January 1, 2017, is:

Cash 92,278
Bonds Payable 92,278
A=L+SE+92,278+92,278
Cash flows: ↑ 92,278 inflow
The journal entry to record the first interest payment on July 1, 2017 and amortization of the discount is:

Interest Expense 4,614


Bonds Payable 614
Cash 4,000
A=L+SE−4,000+614−4,614
Cash flows: ↓ 4,000 outflow
The journal entry to record the interest expense accrued at December 31, 2017 (the year end) and amortization of the
discount is:

Interest Expense 4,645


Interest Payable 4,000
Bonds Payable 645
A=L+SE+4,645−4,645
Cash flows: No effect

Example: Bonds Issued at Premium


If instead it had been a market where the investors were willing to accept an effective interest rate of 6% on the bond
issue described above, they would have paid $108,530 or a premium of $8,530, calculated as in Illustration 14-5.
Maturity value of bonds payable $100,000
Present value of $100,000 due in 5 years at 6%, interest payable semi-annually ($100,000 ×
$74,409
0.74409)
Present value of $4,000, interest payable semi-annually for 5 years at 6% annually ($4,000 ×
34,121
8.53020)
Proceeds from sale of bonds 108,530
Premium on bonds payable $ 8,530
Illustration 14-5 Calculation of Premium on Bonds Payable
The five-year amortization schedule appears in Illustration 14-6.
SCHEDULE OF BOND PREMIUM AMORTIZATION
Effective Interest Method—Semi-Annual Interest Payments
5-Year, 8% Bonds Sold to Yield 6%

Date Cash Paid Interest Expense Premium Amortized Carrying Amount of Bonds
1/1/17 $108,530
7/1/17 $ 4,000a $ 3,256b $ 744c 107,786d
1/1/18 4,000 3,234 766 107,020
7/1/18 4,000 3,211 789 106,231
1/1/19 4,000 3,187 813 105,418
7/1/19 4,000 3,162 838 104,580
1/1/20 4,000 3,137 863 103,717
7/1/20 4,000 3,112 888 102,829
1/1/21 4,000 3,085 915 101,914
7/1/21 4,000 3,057 943 100,971
1/1/22 4,000 3,029 971 100,000
$40,000 $31,470 $8,530
Illustration 14-6 Bond Premium Amortization Schedule
The entry to record the issuance of the Master Corporation bonds at a premium on January 1, 2017 is:

Cash 108,530
Bonds Payable 108,530
A=L+SE+108,530+108,530
Cash flows: ↑ 108,503 inflow
The journal entry to record the first interest payment on July 1, 2017, and amortization of the premium is:

Interest Expense 3,256


Bonds Payable 744
Cash 4,000
A=L+SE−4,000−744−3,256
Cash flows: ↓ 4,000 outflow
Because the discount or premium should be amortized as an adjustment to interest expense over the life of the bond,
it results in a constant interest rate when it is applied to the carrying amount of debt that is outstanding at the
beginning of any specific period.
Accruing Interest
In our examples for Master Corporation up to now, the dates on the amortization tables coincide with the dates of
the interest payments (that is January 1 and July 1). However, what happens if Master wishes to report financial
statements at the end of February 2017? In this case, as Illustration 14-7 shows, the premium is prorated by the
appropriate number of months to arrive at the proper interest expense. Note that if a financial calculator or Excel
were used, the number would be slightly different due to compounding.
Interest accrual ($4,000×26) $1,333.33
Premium amortized ($744×26) (248.00)
Interest expense (Jan. to Feb.) $1,085.33
Illustration 14-7 Calculation of Interest Expense
The journal entry to record this accrual is:

Bonds Payable 248


Interest Expense 1,085
Interest Payable 1,333
A=L+SE+1,085−1,085
Cash flows: No effect
If the company prepares financial statements six months later, the same procedure is followed to amortize the
premium, as Illustration 14-8 shows.
Premium amortized (Mar.-June) ($744×46) $496.00
Premium amortized (July-Aug.) ($766×26) 255.33
Premium amortized (Mar.-Aug. 2017) $751.33
Illustration 14-8 Calculation of Premium Amortization
The calculation is much simpler if the straight-line method is used. In the Master situation, for example, the total
premium is $8,530 and this amount needs to be allocated evenly over the five-year period. The premium
amortization per month is therefore $142 ($8,530 ÷ 60 months).

Special Situations
Non-Market Rates of Interest—Marketable Securities
Financial liabilities should initially be recognized at fair value, which is generally the exchange value that exists
when two arm's-length parties are involved in a transaction. If a zero-interest-bearing (non-interest-
bearing) marketable security is issued for cash only, its fair value is the cash received by the security's issuer. The
implicit or imputed interest rate is the rate that makes the cash that is received now equal to the present value of
the amounts that will be received in the future. This rate should also equal the market rate of interest. The difference
between the security's face amount and the present value is a discount and is amortized to interest expense over the
life of the note.
To illustrate the entries and the amortization schedule, assume that your company is the one that
issued the $10,000, three-year, zero-interest-bearing note to Jeremiah Company that was
illustrated in Chapter 7. Let's assume further that the note is marketable. 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 the date of issuance) was 9%. Assume that the market rate of
interest for a similar note would also be 9%. (The present value of $1 for three periods at 9% is
$0.77218.) The time diagram that shows the one cash flow is as follows:

The entry to record issuance of the note would be:

Cash 7,722
Notes Payable 7,722
A=L+SE+7,722+7,722
Cash flows: ↑ 7,722 inflow
The discount is amortized and interest expense is recognized annually. The three-year discount amortization and
interest expense schedule is shown in Illustration 14-9 using the effective interest method.
SCHEDULE OF NOTE DISCOUNT AMORTIZATION
Effective Interest Method
0% Note Discounted at 9%

Cash Paid Interest Expense Discount Amortized Carrying Amount of Bonds


Date of issue $ 7,721.80
End of year 1 $-0- $ 694.96a $ 694.96b 8,416.76c
End of year 2 -0- 757.51 757.51 9,174.27
End of year 3 -0- 825.73d 825.73 10,000.00
$-0- $2,278.20 $2,278.20
Illustration 14-9 Schedule of Note Discount Amortization
Interest expense at the end of the first year using the effective interest method is recorded as follows:

Interest Expense ($7,722 × 9%) 695


Notes Payable 695
A=L+SE+695−695
Cash flows: No effect
The total amount of the discount, $2,278 in this case, represents the interest expense to be incurred and recognized
on the note over the three years.

Non-Market Rates of Interest—Non-Marketable Instruments


If the loans or notes do not trade on a market (that is, they are not securities) and the interest rate
is a non-market interest rate, the situation must be analyzed carefully. The cash consideration
that is given may not be equal to the fair value of the loan or note. Normally, in an arm's-length
reciprocal transaction, the loan would be issued with an interest rate approximating the market
rate and therefore the consideration would approximate fair value. If the loan is issued with an
interest rate that is less than the market rate, this concession should be accounted for separately.

In these cases, the entity must measure the value of the loan by discounting the cash flows using the market rate of
interest, which is done by considering similar loans with similar terms. Any difference between the cash
consideration and the discounted amount (the fair value of the loan) would be booked to net income unless it
qualified as some other asset or liability.8
For example, assume that a government entity issues at face value a zero-interest-bearing loan that is to be repaid
over five years with no stated interest. In doing this, the government is giving an additional benefit to the company
beyond the debt financing. It is forgiving the interest that the company would normally be charged. Thus, the
company is getting a double benefit—the loan and a grant for the interest that would otherwise be paid. The extra
benefit would be accounted for separately as a government grant.
To illustrate, assume that to help a company finance the construction of a building, the government provides
$100,000 cash, in exchange for a $100,000, five-year, zero-interest-bearing note at face value when the market rate
of interest is 10%. To record the loan, the company records a discount of $37,908, which is the difference between
the loan's $100,000 face amount and its fair value of $62,092 ($100,000 × the present value factor for five years at
10% = $100,000 × 0.62092). The rest may be booked to the related building account under government grant
accounting because it relates to the construction of an asset. The issuer's journal entry is:

Cash 100,000
Notes Payable 62,092
Buildings 37,908
A=L+SE+62,092+62,092
Cash flows: ↑ 100,000 inflow
The discount is subsequently amortized to interest expense. The net value of the building (that is, net of the
government grant) is depreciated, thus spreading the grant over the life of the asset. 9 In this situation, the write-off
of the discount and the amortization of the government grant are at different rates.
Notes Issued for Property, Goods, and Services
When a non-marketable debt instrument is exchanged for property, goods, or services in a bargained, arm's-length
transaction, there are additional measurement issues. As with other transactions, it should be booked at fair value.
But what is the fair value? If the issued debt is a marketable security, the value of the transaction would be easy to
determine. If it is not, we must try to estimate the fair value. Normally, for monetary transactions, when measuring
the transaction's price, we first try to measure the value of the monetary asset or liability and, if this is not possible,
we then attempt to value the nonmonetary assets in the transaction. In this case, the note is a monetary liability and
so we would try to value this first. The note could be valued using a valuation technique such as discounting. Similar
to the previous example, the cash flows from the debt instrument could be discounted using a market rate of interest
for similar debt with similar terms. If this is not possible, and if the fair value of the property, goods, or services is
readily determinable, this fair value of the property, goods, or services could then be used to measure the
transaction.
For example, assume that Scenic Development sold land having a cash sale price of $200,000 to Health Spa Inc. in
exchange for Health Spa's five-year, $293,860, zero-interest-bearing note. The $200,000 cash sale price represents
the present value of the $293,860 note discounted at 8% for five years. The 8% interest rate is the market rate for a
similar loan with similar terms. If both parties were to record the transaction on the sale date at the $293,860 face
amount of the note, Health Spa's Land account and Scenic's sales would be overstated by $93,860. This is because
the $93,860 is the interest for five years at an effective rate of 8%. Interest revenue to Scenic and interest expense to
Health Spa for the five-year period would also then be correspondingly understated by $93,860.
The transaction could be measured by using a valuation technique to measure the value of the debt or alternatively
by using the fair value of the land ($200,000) if it is not possible to measure the debt. In this case, we know the fair
value of the land and we also know that the market rate is 8%. Because the present value of the note is equal to the
land value, we use $200,000. The difference between the cash sale price of $200,000 and the face amount of the
note, $293,860, represents interest at an effective rate of 8%.The transaction is recorded at the exchange date as
follows:

Health Spa Inc. Scenic Development Company


Land 200,000 Notes Receivable 200,000
Notes Payable 200,000 Sales Revenue 200,000
A=L+SE+200,000+200,000
Cash flows: No effect
A=L+SE+200,000+200,000
Cash flows: No effect
During the five-year life of the note, Health Spa annually amortizes a portion of the discount of $93,860 as a charge
to interest expense. Scenic Development records interest revenue totalling $93,860 over the five-year period by also
amortizing the discount.
If a higher interest rate were determined to be the market rate of interest, the land and selling price would be
measured at a lower amount because there is an inverse relationship between the discount rate and the present value
of the cash flows. This might cause us to question whether the land's so-called cash sales price has been overstated
because the vendor would want to receive consideration equal to the land's fair value. At some point, a judgement
call is required to determine which is more reliable: the imputed interest rate or the asset's stated fair value.

Fair Value Option


Generally, long-term debt is measured at amortized cost; however, as discussed earlier in the text,
there is an option to value financial instruments at fair value (referred to as the fair value option).
Although ASPE allows the fair value option for all financial instruments, IFRS explicitly requires
that the option be used only where fair value results in more relevant information. This would be the
case where the use of fair value eliminates or reduces measurement and/or recognition
inconsistencies or where the financial instruments are managed or performance is evaluated on a fair
value basis.
One significant issue arises when the fair value option is used for measuring the entity's own debt
instruments. As a general rule, fair value should always incorporate information about the riskiness
of the cash flows associated with a particular instrument (including information about the entity's
own liquidity and solvency). However, this gives some peculiar and counterintuitive results; that is,
if the debt increases in risk, it would have a lower fair value, thus resulting in recognition of a gain
for the company that issued it. Therefore, even though the company is worse off, it recognizes a gain.
IFRS 13, which deals with fair value measurement, requires that non-performance risk (which includes credit risk)
be included in the fair value measurement.10IFRS 9 requires that subsequent changes in fair value due to changes in
credit risk that arise on remeasurement of the fair value of financial liabilities under the fair value option be
presented in other comprehensive income.11 Under ASPE, all changes in fair value are recognized in net income
where the fair value option is selected.
As an example, assume that Friction Limited has bonds outstanding in the amount of $100,000. The
company has chosen to apply the fair value option in accounting for this liability. At the end of the
current year, the company's credit risk has increased and therefore the fair value of its debt is
$95,000. Assume that the change in fair value is due solely to the change in credit risk.

Illustration 14-10 shows how the gain would be accounted for.


IFRS: IFRS 9 ASPE
To record the change in fair value of debt that is accounted for under the fair
value option
Bonds Payable 5,000 5,000
Unrealized Gain or Loss 5,000
Unrealized Gain or Loss—OCI 5,000
A=L+SE−5,000+5,000
Cash flows: No effect
Illustration 14-10 Use of the Fair Value Option in Valuing a Long-Term Liability (IFRS versus ASPE)

Recognition and Derecognition


Objective 3
Understand when long-term debt is recognized and derecognized, including how to account for troubled debt
restructurings.
Like all financial instruments, long-term debt is recognized in the financial statements when the company becomes
party to the contractual provisions (when the financing deal is finalized or bonds are issued). The debt remains on
the books until it is extinguished. When debt is extinguished, it is derecognized from the financial statements. If the
instrument is held to maturity, no gain or loss is calculated. This is because any premium or discount and any issue
costs will be fully amortized at the date the instrument matures. As a result, the carrying amount will be equal to the
instrument's maturity (face) value. And as the maturity or face value is also equal to the instrument's market value at
that time, there is no gain or loss.
From a financial reporting perspective, the extinguishment of debt is recorded when either of the following occurs:
 1.The debtor discharges the liability by paying the creditor.
 2.The debtor is legally released from primary responsibility for the liability by law or by the creditor (for
example, due to cancellation or expiry).12
Repayment before Maturity Date
In some cases, debt is extinguished before its maturity date. The amount paid on extinguishment before maturity,
including any call premium and expenses of reacquisition or early repayment, is called the reacquisition price. On
any specified date, the bond's net carrying amount is the amount that is payable at maturity, adjusted for any
unamortized premium or discount and cost of issuance. If the net carrying amount is more than the reacquisition
price, the excess amount is a gain from extinguishment. Conversely, if the reacquisition price exceeds the net
carrying amount, the excess is a loss from extinguishment. At the time of reacquisition, the unamortized premium or
discount and any costs of issue that apply to the bonds must be amortized up to the reacquisition date.
To illustrate, assume that on January 1, 2017, General Bell Corp. issued bonds with a par value of $800,000 at 97
(which is net of issue costs), due in 20 years. Eight years after the issue date, the entire issue is called at 101 and
cancelled. The loss on redemption (extinguishment) is calculated as in Illustration 14-11, which uses straight-line
amortization for simplicity.
Reacquisition price ($800,000 × 1.01) $808,000
Net carrying amount of bonds redeemed:
Face value $800,000
Unamortized discount ($24,000×1220)a (amortized using straight-line basis) (14,400) 785,600
Loss on redemption $ 22,400
Illustration 14-11 Calculation of Loss on Redemption of Bonds
The entry to record the reacquisition and cancellation of the bonds is:

Bonds Payable 785,600


Loss on Redemption of Bonds 22,400
Cash 808,000
A=L+SE−808,000−785,600−22,400
Cash flows: ↓ 808,000 outflow

Exchange of Debt Instruments


The replacement of an existing issuance with a new one is sometimes called refunding. Generally, an exchange of
debt instruments that have substantially different terms between a borrower and lender is viewed as an
extinguishment of the old debt and the issuance of a new one. 13
Companies may refund or replace debt to get more favourable terms. These early extinguishments would generally
be bound by the initial debt agreement. (For example, there are provisions that allow early repayment.) The debtor
may experience a loss and sometimes a gain depending on the prepayment options in the original agreement. If the
bonds are marketable securities, the company can simply buy them back in the marketplace.

If the new debt is substantially the same as the old debt, the economic substance is that it is a continuation of the old
debt, even though, legally, the old debt may have been settled.
Sometimes, however, companies are forced to repay or restructure their debt because they cannot make interest and
principal payments. This is sometimes referred to as troubled debt restructuring. An example of the accounting for a
settlement through an exchange of debt instruments is noted in the next section.

Troubled Debt Restructurings


A troubled debt restructuring occurs when, for economic or legal reasons that are related to the debtor's
financial difficulties, a creditor grants a concession to the debtor that it would not offer in ordinary
circumstances. This is what separates a troubled debt restructuring from an ordinary early repayment or
exchange.

A troubled debt restructuring can be either one of these two basic types of transactions:
 1.Settlement of the debt at less than its carrying amount
 2.Continuation of the debt, but with a modification of its terms
Settlement of Debt

When the debt is settled, meaning there is early repayment or refunding, this is referred to as debt
settlement. In this case, the old debt and all related discount, premium, and issuance costs will be
removed from the debtor's books. (That is, they will be derecognized.) Unlike with a normal early
repayment or refunding, a gain will usually be recognized in most cases because the creditor
generally makes favourable concessions to the debtor in troubled debt situations. The creditor
removes the loan receivable from its books and may recognize a further loss.
In order to settle the debt, the debtor may do one of the following:
 1.Transfer non-cash assets (real estate, receivables, or other assets).
 2.Issue shares.
 3.Issue new debt to another creditor and use the cash to repay the existing debt.
If non-cash assets are used to settle the debt, the debtor will recognize a gain or loss on the disposal of the asset for
the amount of the difference between the fair value of those assets and their carrying amount (book value). The
creditor may force the debtor to transfer the asset if there is a legal charge on the asset (such as in the case of
collateral or a mortgage). This is referred to as a loan foreclosure. The creditor takes the underlying security (the
asset) as a replacement for payment of the loan.
To illustrate a transfer of assets, assume that Halifax City Bank has loaned $20 million to Union Trust. Union Trust
in turn has invested these monies in residential apartment buildings, but because of low occupancy rates it cannot
meet its loan obligations. Halifax City Bank agrees to accept from Union Trust a building with a fair value of $16
million in full settlement of the $20-million loan obligation. The building has a recorded value of $21 million on the
books of Union Trust, net of accumulated depreciation of $5 million. For simplicity, assume that no prior allowance
for doubtful accounts has been set up on the note and no impairment has been recognized on the building. 14 The
entry to record this transaction on the books of Halifax City Bank (the creditor) is as follows:
Buildings 16,000,000
Loss on Loan Settlement 4,000,000
Notes Receivable 20,000,000
A=L+SE−4,000,000−4,000,000
Cash flows: No effect
The building is recorded at its fair value, and a charge is made to the income statement to reflect the loss. 15
The entry to record this transaction on the books of Union Trust (the debtor) is as follows:

Accumulated Depreciation—Buildings 5,000,000


Notes Payable 20,000,000
Loss on Sale of Buildings (NBV − FV = 21,000,000 − 16,000,000) 5,000,000
Buildings 26,000,000
Gain on Restructuring of Debt (FV of loan − FV of payment = 20,000,000 − 4,000,000
16,000,000)
A=L+SE−21,000,000−20,000,000−1,000,000
Cash flows: No effect
Union Trust has a loss on the disposal of the building in the amount of $5 million, which is the difference between
the $21-million book value and the $16-million fair value. In addition, it has a gain on restructuring of debt of $4
million, which is the difference between the $20-million carrying amount of the note payable and the $16-million
fair market value of the real estate.
To illustrate the granting of an equity interest (that is, shares), assume that Halifax City Bank had agreed to accept
from Union Trust 320,000 of Union's common shares, with a market value of $16 million, in full settlement of the
$20-million loan obligation. Assume also that the bank had previously recognized a loss on impairment of $4
million. Halifax decides to treat the investments as FV-NI. The entry to record this transaction on the books of
Halifax City Bank (the creditor) is as follows:

FV-NI Investments 16,000,000


Allowance for Doubtful Accounts 4,000,000
Notes Receivable 20,000,000
A=L+SE0
Cash flows: No effect
The shares that are received by Halifax City Bank are recorded as an investment and at their fair value (equal to
market value) on the date of the restructuring.
The entry to record this transaction on the books of Union Trust (the debtor) is as follows: 16
Notes Payable 20,000,000
Common Shares 16,000,000
Gain on Restructuring of Debt 4,000,000
A=L+SE−20,000,000+20,000,000
Cash flows: No effect
In some cases, a debtor will have serious short-term cash flow problems that lead it to request one or a combination
of the following modifications:
 1.Reduction of the stated interest rate
 2.Extension of the maturity date of the debt's face amount
 3.Reduction of the debt's face amount
 4.Reduction or deferral of any accrued interest
 5.Change in currency
If there are substantial modifications, the transaction is treated like a settlement. The modifications would be
considered substantial in either of these two situations:
 1.The discounted present value under the new terms (discounted using the original effective interest rate) is at
least 10% different from the discounted present value of the remaining cash flows under the old debt.
 2.There is a change in creditor and the original debt is legally discharged.17
If one of these conditions is met, the transaction is considered a settlement. Otherwise, it is treated as a modification.
When the economic substance is a settlement, the old liability is eliminated and a new liability is assumed. The new
liability is measured at the present value of the revised future cash flows discounted at the current prevailing market
interest rate, as is done for the initial recording of a bond. The gain is measured as the difference between the current
present value of the revised cash flows and the carrying value of the old debt.
Assume that on December 31, 2017, Manitoba National Bank enters into a debt restructuring agreement with
Resorts Development Corp., which is experiencing financial difficulties. The bank restructures a $10.5-million loan
receivable issued at par (interest paid up to date) by doing all of the following:
 1.It reduces the principal obligation from $10.5 million to $9 million.
 2.It extends the maturity date from December 31, 2017 to December 31, 2021.
 3.It reduces the interest rate from 12% to 8%. (The market rate is currently 9%.)
Is this a settlement or a modification? Has a substantial modification in the debt occurred? The test to establish
whether this is a settlement or not involves the cash flows. The present value of both cash flow streams is calculated
as follows, using the historic rate as the discount rate for consistency and comparability:

Old debt: PV = $10,500,000 (because the debt is currently due)


New debt: PV = $9,000,000 (PVF4,12%) + $720,000 (PVFOA4,12%) (see Tables A-2 and A-4)
New debt: PV = $9,000,000 (0.63552) + $720,000 (3.03735) = $7,906,572
The new debt's value differs by more than 10% of the old debt's value, so the renegotiated debt would therefore be
considered a settlement, and a gain would be recorded through the following journal entry:

Notes Payable 10,500,000


Notes Payable 8,708,468
Gain on Restructuring of Debt 1,791,532
A=L+SE−1,791,532+1,791,532
Cash flows: No effect
Because it is new debt, it would be recorded at the present value of the new cash flows at the market interest rate as
follows: PVF4,9% + PVFOA4,9% = $9,000,000 (0.70843) + $720,000 (3.23972) = $8,708,468.
Manitoba National Bank would record a modification gain or loss. The recorded amount of the loan receivable
would be reduced to the amount of the net cash flows receivable (but under the modified terms) discounted at the
historical effective interest rate that is inherent in the loan. Because it is a restructuring, the uncollectible amount
would be written off (as opposed to setting up an allowance). At the date of restructuring, Manitoba National Bank
would record a loss of $2,193,428 (assuming it had previously recognized an impairment of $400,000) through the
following journal entry:

Modification Gain or Loss 2,193,428


Notes Receivable 7,906,572
Allowance For Doubtful Accounts 400,000
Notes Receivable 10,500,000
A=L+SE−2,193,428−2,193,428
Cash flows: No effect

Non-Substantial Modification of Terms


Where debt is exchanged but the terms of the new debt are not substantially different (modified) from the old debt,
the accounting is different. The old debt is seen to continue to exist but with new terms. A new effective interest rate
is imputed by equating the carrying amount of the original debt with the present value of the revised cash flows.
Looking back to our example above for Manitoba National Bank and Resorts Development Corp., if the substantial
modification test was not met, the debt would remain on the books at $10.5 million and no gain or loss would be
recognized. As a result, no entry would be made by Resorts Development Corp. (debtor) at the date of restructuring.
The debtor would calculate a new effective interest rate, however, in order to record interest expense in future
periods. In this case, the new rate is calculated by relating the prerestructure carrying amount ($10.5 million) to the
total future cash flows ($9,000,000 + [4 × $720,000]). Using a financial calculator or spreadsheet formula, we can
determine that the rate to discount the total future cash flows ($11,880,000) to the present value that is equal to the
remaining balance ($10.5 million) is 3.46613%.
Based on the effective rate of 3.46613%, the schedule in Illustration 14-12 is prepared.
RESORTS DEVELOPMENT CORP. (DEBTOR)
Interest Paid Interest Expense Reduction of Carrying Carrying Amount of
Date (8%) (3.46613%) Amount Note
12/31/17 $10,500,000
12/31/18 $ 720,000a $ 363,944b $ 356,056c 10,143,944
12/31/19 720,000 351,602 368,398 9,775,546
12/31/20 720,000 338,833 381,167 9,394,379
12/31/21 720,000 325,621 394,379 9,000,000
$2,880,000 $1,380,000 $1,500,000
Illustration 14-12 Schedule Showing Reduction of Carrying Amount of Note
Thus, on December 31, 2018 (the date of the first interest payment after the restructuring), the debtor makes the
following entry:

December 31, 2018


Notes Payable 356,056
Interest Expense 363,944
December 31, 2018
Cash 720,000
A=L+SE−720,000−356,056−363,944
Cash flows: ↓ 720,000 outflow
A similar entry (except for different amounts for debits to Notes Payable and Interest Expense) is made each year
until maturity. At maturity, the following entry is made:

December 31, 2021


Notes Payable 9,000,000
Cash 9,000,000
A=L+SE−9,000,000−9,000,000
Cash flows: ↓ 9,000,000 outflow
In this case also, Manitoba National Bank would account for the restructuring in the same way as if there had been a
substantial modification.
The decision tree in Illustration 14-13 summarizes the process for deciding how to account for early retirements and
modifications of debt.

Illustration 14-13 Accounting for Early Retirements and Modifications of Debt


Note that in other than troubled debt situations, companies would generally not exchange debt because there is little
economic incentive to do so. They would either buy back the debt in the open market or exercise an early
prepayment option, if one existed in the original debt agreement. Thus the accounting would take the form of
settlement accounting and the debt would be derecognized.
Defeasance Revisited
Earlier in the chapter, we discussed defeasance. Let's revisit defeasance and look at the accounting. Where legal
defeasance occurs, the debt is extinguished and the creditor looks to the trust for repayment. The creditor no longer
has any claim on the company and therefore the company treats the transaction as an extinguishment and thus
derecognizes the liability.
In some cases, however, the company does not inform the creditor of the arrangement or the creditor does not
release the company from the primary obligation to settle the debt. Thus the original loan agreement is still in force.
This version of the arrangement is often called in-substance defeasance. Does in-substance defeasance result in
extinguishment of the debt on the company's books? In essence, if the trust is properly set up—for example, the
money is invested in low-risk or risk-free investments in an irrevocable trust—it can be argued that the debt has
been prepaid and there is little risk to the company. On the other hand, the company still has the primary obligation
according to the original loan agreement. IFRS and ASPE do not allow derecognition of debt under in-substance
defeasance arrangements because the company still owes the money.
Off-Balance Sheet Financing
Off-balance sheet financing occurs when a company structures a financing deal that results in the
obligations not being recorded as debt on the statement of financial position. It is an issue of extreme
importance to accountants as well as to general management. Because increased debt signals increased
solvency risk, there is a reporting bias to keep low debt levels on the statement of financial position
(SFP). From a user perspective, however, the amount of debt is very relevant and, in the interest of
transparency, all debt should be recognized on the SFP. This is an area where the level of information
asymmetry may be significant.
Off-balance sheet financing can take many different forms. The accounting issues can be complex and IFRS and
ASPE differ as to how to account for these items. Because these items are dealt with in more detail in other chapters
and courses, we will not cover the specific GAAP differences here.
Some examples of off-balance sheet financing follow.
 1.Non-consolidated entities: Under GAAP, a parent company does not have to consolidate
an entity that is less than 50% owned where there is no control. IFRS 10 defines control.
ASPE has differing standards regarding what constitutes control, as was discussed in
Chapter 2. In addition, ASPE allows an accounting policy choice between the equity
method and cost, even where control does exist. In such cases, the parent therefore does
not report the assets and the liabilities of the entity. Instead, the parent reports only the
investment on its statement of financial position. As a result, users of the financial
statements might not understand that the entity has considerable debt that the parent may
ultimately be liable for if the entity runs into financial difficulty. Investments were
discussed in Chapter 9.
 2.Special purpose entities or variable interest entities:
A special purpose entity (SPE) or variable interest entity (VIE) is an entity that a
company creates to perform a special project or function. For example, SPEs or VIEs
might be formed to do the following:
o (a)Access financing. For example, companies sometimes set up SPEs and VIEs to
buy assets, such as accounts receivable or investments, from the company. The
company then sells the assets to the SPE/VIE in return for cash, thus obtaining
financing. Investors invest in the SPE/VIE to benefit from the return on the assets
and certain tax advantages. This process is known as a securitization of assets. In
this way, the company essentially takes a pool of assets and turns it into securities.
Whether the company treats this as a sale or financing was discussed in Chapter 7.
o (b)Take on risk from the company. As in the example above, the sale of the
receivables or investments eliminates price and cash flow risks for the company
because it now holds cash instead of the riskier receivables or investments. The
SPEs/VIEs provide a ready market for buying the assets.
o (c)Isolate certain assets from other company assets. For example, the pension
assets of company employees are often segregated in a trust fund or SPE. This
arrangement allows greater security for the employees and the company gets certain
tax advantages when it contributes money to the plan. Chapter 19 discusses
recognition of unfunded pension obligations.

SPEs and VIEs thus serve valid business functions. They only become a problem
when they are used primarily to make a company's statement of financial position look
better by disguising risk. As a general rule, these entities should be consolidated when
the company is the main beneficiary of the SPE/VIE. Except for the overview we just
presented, the accounting for SPEs and VIEs is beyond the scope of this book.

 3.Operating leases:

Another way that companies keep debt off the SFP is by leasing. Instead
of owning the assets, companies lease them. By meeting certain conditions, the company
has to report only rent expense each period and provide note disclosure of the
transaction. Chapter 20 discusses accounting for leases. IFRS now requires most leases to
be fully recognized.
The accounting profession's response to these off-balance sheet financing arrangements has been to tighten up the
accounting guidance for guarantees, SPEs, leases, and pensions and also to mandate increased note disclosure
requirements. This response follows an efficient markets philosophy. The important question has not been whether
the presentation is off-balance sheet, but whether the items are disclosed at all.18
As part of the conceptual framework project, the IASB has been working on this issue of what constitutes the
economic entity.