accounting assighment

Unit - 2

Financial Instruments as Long-term Liabilities

Financial Instruments are obligations that are expected to be paid more than one year in the future. Bond Payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities are the examples of long term liabilities. A corporation usually requires approval by the board of directors and the stockholders before bonds or notes can be issued.

Bond Characteristics: A bond represents a security issued in connection with a borrowing arrangement. A bond obligates the issuer to make specified payments (interest and principal) to the bondholder. A bond may be described in terms of par value, coupon rate, and maturity date. The par value is the value stated on the face of the bond. It represents the amount the issuer promises to pay at the time of maturity. The coupon rate is the interest rate payable to the bondholder. The maturity date is the date when the principal amount is payable to the bondholder. The bond indenture is the contract between the issuer and the bondholder specifies the par value, coupon rate, and maturity date.

Types of Bonds: There are different types of bonds which are given below:

1. Secured and Unsecured Bonds: Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A bond secured by real estate is called a mortgage bond. A bond secured by specific assets set aside to redeem the bonds is called a sinking fund bond. Unsecured bonds are debenture bonds. They are issued against the general credit of the borrower. Companies with good credit ratings use these bonds extensively.

2. Term and Serial Bonds: Bonds that mature at a single specified future date are term bonds. On the other hand, bonds that mature in installments are serial bonds.

3. Registered and Bearer Bonds: Bonds issued in the name of the owner are registered bonds. Interest payments on registered bonds are made after checking the bondholders’ record. Bonds not registered are bearer or coupon bonds. Holders of bearer bonds must send in coupons to receive interest payments. Most bonds issued today are registered bonds.

4. Convertible Bonds: Convertible bonds give the bond holder the right (option) to convert them into equity shares on certain terms.

5. Callable Bonds: Callable bonds give the issuer the right (option) to redeem them prematurely on certain terms.

6. Commodity backed bonds: Commodity backed bonds are repayable in measures of a commodity such as oil, coal etc.

7. Deep discount or Zero-interest debenture bonds: The deep discount bonds, also known as zero interest bonds, are sold at a discount.

Accounting for Bond issues: A corporation records bond transactions when it issues or redeems bonds and when bondholders convert bonds into common stock. Bonds may be issued at face value (par), at discount and at premium. Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond.

Journal Entries for Issuing Bond: Following entries will be passed in the books of issuing company at the time issuing bonds at par, discount and premium.

Issue of Bonds at par:

Cash debited

Bonds Payable credited

Payment of Interest on Bonds in cash within accounting period:

Bond Interest Expenses debited

Cash credited

If bond interest expense is payable at the end of the accounting period.

Bond interest expenses debited

Bond Interest Payable credited

Issue of Bonds at discount:

Cash debited

Discount on Bonds Payable debited

Bond Payable credited

Payment of interest and Amortization of Discount to interest expenses each year:

Bond Interest Expenses debited

Discount on Bonds Payable credited

Cash credited

Issue of Bonds at Premium:

Cash debited

Premium on Bonds Payable credited

Bonds Payable credited

Payment of Interest and Amortization of Premium to interest expenses each year:

Bond Interest Expenses debited

Premium on Bonds Payable debited

Cash credited

Debt Extinguishments gains and losses: 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 specific date, the net carrying amount of the bonds is the amount payable at maturity, adjusted for unamortized premium or discount, and cost of issuance. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the net carrying amount is a loss from extinguishment.

Off- Balance Sheet financing: Off- balance sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations. It has become an issue of extreme importance. Many allege that Enron, is one of the largest corporate failures on record, hid a considerable amount of its debt off the balance sheet. As a result, any company that uses off-balance sheet financing today risks investors dumping their stocks.

Different forms of off- balance sheet financing: Following are the many forms of Off-balance sheet financing.

1. Non-consolidated Subsidiary: Under GAAP, a parent company does not have to consolidate a subsidiary company that is less than 50 percent owned. In such cases, the parent therefore does not report the assets and liabilities of the subsidiary. As a result, users of the financial statements may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty.

2. Special Purpose Entity (SPE): A company creates a special purpose entity to perform a special project. For example, Clarke Company decides to build a new factory. However, management does not want to report the plant or the borrowing used to fund the construction on its balance sheet. It therefore creates an SPE, the purpose of which is to build the plant. This arrangement is called a project financing arrangement. In return Clark guarantees that it or some outside party will purchase all the products produced by the plant. As a result, Clark might not report the asset or liability on its books.

3. Operating Leases: Another way that companies keep debt off the balance sheet is by leasing. Instead of owning the assets, companies lease them. Again, by meeting certain conditions, the company has to report only rent expense each period and to provide note disclosure of the transaction. Special purpose entity (SPE) often uses leases to accomplish off-balance sheet treatment.

Rationale behind the off-balance sheet financing is that many believe that removing debt enhances the quality of the balance sheet and permits credit to obtained more readily and at less cost. Second, the loan covenants often limit the amount of debt a company may have. As a result, the company uses off-balance sheet financing, because these types of commitments might not be considered in computing the debt limitation.

Workout Problems:

Q.1 Three year bonds are issued at face value of SR100,000 on Jan. 1, 2007, a stated interest rate of 8%, and market rate of 8%.

Q.2 STC Company issues at par 10 years' term bonds with a par value of SR 800,000, dated January 1, 2007, and bearing interest at an annual rate of 10% payable semi-annually on January 1 and July1.

Pass necessary entries for one year in the books of STC.

Q.3 Three year bonds are issued at face value of SR 100, 000 on Jan. 1, 2007, at a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 10%. The present value of SR 1 is .75132 at 10% after 3 years and the present value of an ordinary annuity of SR 1 is 2.48685 at 10% after 3 years. Prepare discount amortization table and journal entries for three years.

Q.4 SAPTCO issues SR 600, 000 bonds at the rate of 7% on January 1, 2008, at 97% for 3 years. Pass the necessary entries for one year.

Q.5 SAPTCO issues SR 400, 000 bonds at the rate of 9% on January 1, 2008, at 106% for 3 years. Pass the necessary entries for one year.

Q.6 Three year bonds are issued at face value of SR 100,000 on Jan. 1, 2007, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 6%. The present value of SR 1 is .83962 at 6% after 3 years and the present value of an ordinary annuity of SR 1 is 2.67301 at 6% after 3 years.

Q.7. Three year 8% bonds of SR 100,000 issued on Jan. 1, 2007, are recalled at 105 on Dec. 31, 2008. Expenses of recall are SR 10,000. Market interest on issue date was 8%.

Q8. On Jan. 1, 2010, General Bell Corporation issued at 97%, bonds with a par value of SR 800,000 due in 20 years. It incurred bond issue cost totaling SR 16,000. Eight years after the issue date, General Bells calls the entire issue at 101% and cancels it. Compute the loss or gain on redemption (extinguishment).

Q.9. On Jan. 1, 2011, STC retired SR 500,000 of bonds at 99%. At the time of retirement, the unamortized premium was SR 15,000 and unamortized bond issue costs were SR 5,250. Prepare journal entries of reacquisition of bonds in the books of STC.