UU IFA II Melaku K.

CHAPTER FIVE
Long-term Financial Liabilities
5.1. Bond Payable
Non-current liabilities (sometimes referred to as long-term debt) consist of an expected outflow
of resources arising from present obligations that are not payable within a year or the operating
cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages
payable, pension liabilities, and lease liabilities are examples of non-current liabilities.
A company usually requires approval by the board of directors and the shareholders before bonds
or notes can be issued. The same holds true for other types of long-term debt arrangements.
Generally, long-term debt has various covenants or restrictions that protect both lenders and
borrowers. The indenture or agreement often includes the amounts authorized to be issued,
interest rate, due date(s), call provisions, property pledged as security, sinking fund
requirements, working capital and dividend restrictions, and limitations concerning the
assumption of additional debt. Companies should describe these features in the body of the
financial statements or the notes, if important for a complete understanding of the financial
position and the results of operations.
Although it would seem that these covenants provide adequate protection to the long-term debt-
holder, many bondholders suffer considerable losses when companies add more debt to the
capital structure.
Types of Bonds
Secured and Unsecured Bonds: Secured bonds are backed by a pledge of some sort of
collateral. Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are
secured by shares and bonds of other companies. Bonds not backed by collateral are unsecured.
A debenture bond is unsecured. A “junk bond” is unsecured and also very risky, and therefore
pays a high interest rate. Companies often use these bonds to finance leveraged buyouts.
Term, Serial Bonds, and Callable Bonds: Bond issues that mature on a single date are called
term bonds; issues that mature in installments are called serial bonds. Serially maturing bonds
are frequently used by school or sanitation districts, municipalities, or other local taxing bodies
that receive money through a special levy. Callable bonds give the issuer the right to call and
retire the bonds prior to maturity.

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Convertible Bonds: If bonds are convertible into other securities of the company for a specified
time after issuance, they are convertible bonds.
Deep-discount bonds, also referred to as zero-interest debenture bonds, are sold at a discount
that provides the buyer’s total interest payoff at maturity, with no periodic interest payments.
Registered and Bearer (Coupon) Bonds. Bonds issued in the name of the owner are registered
bonds and require surrender of the certificate and issuance of a new certificate to complete a
sale. A bearer or coupon bond, however, is not recorded in the name of the owner and may be
transferred from one owner to another by mere delivery.
Income and Revenue Bonds: Income bonds pay no interest unless the issuing company is
profitable. Revenue bonds, so called because the interest on them is paid from specified revenue
sources, are most frequently issued by airports, school districts, counties, toll-road authorities,
and governmental bodies.
Issuing Bonds
A bond arises from a contract known as a bond indenture. A bond represents a promise to pay
(1) a sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on
the maturity amount (face value). Individual bonds are evidenced by a paper certificate and
typically have a Br 1,000 face value. Companies usually make bond interest payments
semiannually, although the interest rate is generally expressed as an annual rate. The main
purpose of bonds is to borrow for the long term when the amount of capital needed is too large
for one lender to supply. By issuing bonds in Br. 100, Br. 1,000, or Br. 10,000 denominations, a
company can divide a large amount of long-term indebtedness into many small investing units,
thus enabling more than one lender to participate in the loan.
A company may sell an entire bond issue to an investment bank, which acts as a selling agent in
the process of marketing the bonds. In such arrangements, investment banks could underwrite
the entire issue by guaranteeing a certain sum to the company, thus taking the risk of selling the
bonds for whatever price they can get (firm underwriting). Or, the underwriters could sell the
bond issue for a commission on the proceeds of the sale (best-efforts underwriting).
Alternatively, the issuing company could sell the bonds directly to a large institution, financial
or otherwise, without the aid of an underwriter (private placement).

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Valuation and Accounting for Bonds Payable

The issuance and marketing of bonds to the public does not happen overnight. It usually takes
weeks or even months. First, the issuing company must arrange for underwriters which will help
market and sell the bonds. Then, it must obtain regulatory approval of the bond issue, undergo
audits, and issue a prospectus (a document that describes the features of the bond and related
financial information). Finally, the company must generally have the bond certificates printed.
Frequently, the issuing company establishes the terms of a bond indenture well in advance of the
sale of the bonds. Between the times the company sets these terms and the time it issues the
bonds, the market conditions and the financial position of the issuing company may change
significantly. Such changes affect the marketability of the bonds and thus their selling price.
The selling price of a bond issue is set by the supply and demand of buyers and sellers, relative
risk, market conditions, and the state of the economy. The investment community values a bond
at the present value of its expected future cash flows, which consist of (1) interest and (2)
principal. The rate used to compute the present value of these cash flows is the interest rate that
provides an acceptable return on an investment commensurate with the issuer’s risk
characteristics.
The interest rate written in the terms of the bond indenture (and often printed on the bond
certificate) is known as the stated, coupon, or nominal rate. The issuer of the bonds sets this
rate. The stated rate is expressed as a percentage of the face value of the bonds (also called the
par value, principal amount, or maturity value).
Bonds Issued at Par
If the rate employed by the investment community (buyers) is the same as the stated rate, the
bond sells at par. That is, the par value equals the present value of the bonds computed by the
buyers (and the current purchase price). To illustrate the computation of the present value of a
bond issue, assume that Ambassel Trading issues Br. 100,000 in bonds dated January 1, 2022,
due in five years with 9 percent interest payable annually on January 1.
The actual principal and interest cash flows are discounted at a 9 percent rate for five periods, as
Shown Below:

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Present value of the principal:

Br. 100,000 × .64993 Br. 64,993
Present value of the interest payments:
Br. 9,000 × 3.88965 35,007
Present value (selling price) of the bonds Br.100, 000
(Present Value Computation of Bond Selling at Par)
By paying Br. 100,000 (the par value) at the date of issue, investors realize an effective rate or
yield of 9 percent over the five-year term of the bonds. Ambassel makes the following entries in
the first year of the bonds.
January 1,2022 (issue Bonds)
Cash Br. 100,000
Bond payable Br. 100,000
Decmber 31,2022 (Accrued interest Expense)
Interest expense (100,00*9%) Br. 9,000
Interest payable Br. 9,000
January 1,2023 (first interest payment)
Interest payable Br. 9,000
Cash Br. 9,000
Bonds Issued at Discount or Premium
If the rate employed by the investment community (buyers) differs from the stated rate, the
present value of the bonds computed by the buyers (and the current purchase price) will differ
from the face value of the bonds. The difference between the face value and the present value of
the bonds determines the actual price that buyers pay for the bonds. This difference is either a
discount or premium.
If the bonds sell for less than face value, they sell at a discount.
If the bonds sell for more than face value, they sell at a premium.
The rate of interest actually earned by the bondholders is called the effective yield or market
rate. If bonds sell at a discount, the effective yield exceeds the stated rate. Conversely, if bonds
sell at a premium, the effective yield is lower than the stated rate. Several variables affect the
bond’s price while it is outstanding, most notably the market rate of interest. There is an inverse
relationship between the market interest rate and the price of the bond.

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To illustrate, assume now that Ambassel issues Br. 100,000 in bonds, due in five years with 9
percent interest payable annually at year-end. At the time of issue, the market rate for such bonds
is 11 percent.
The actual principal and interest cash flows are discounted at an 11 percent rate for five periods,
as shown in the table.
Present value of the principal:
Br. 100,000 × .59345 Br. 59,345
Present value of the interest payments:
Br. 9,000 × 3.69590 33,263
Present value (selling price) of the bonds Br. 92,608
(Present Value Computation of Bond Selling at a Discount)
By paying Br. 92,608 at the date of issue, investors realize an effective rate or yield of 11 percent
over the five-year term of the bonds. These bonds would sell at a discount of Br. 7,392 (Br.
100,000 − 92,608). The price at which the bonds sell is typically stated as a percentage of the
face or par value of the bonds. For example, the Amabassel bonds sold for 92.6 (92.6% of par).
If Ambassel had received Br. 102,000, then the bonds sold for 102 (102% of par).
When bonds sell at less than face value, it means that investors demand a rate of interest higher
than the stated rate. Usually, this occurs because the investors can earn a higher rate on
alternative investments of equal risk. The investors cannot change the stated rate, so they refuse
to pay face value for the bonds. Thus, by changing the amount invested, they alter the effective
rate of return. The investors receive interest at the stated rate computed on the face value, but
they actually earn at an effective rate that exceeds the stated rate because they paid less than
face value for the bonds.
Effective-Interest Method
As discussed earlier, by paying more or less at issuance, investors earn a rate different than the
coupon rate on the bond. Recall that the issuing company pays the contractual interest rate over
the term of the bonds but also must pay the face value at maturity. If the bond is issued at a
discount, the amount paid at maturity is more than the issue amount. If issued at a premium, the
company pays less at maturity relative to the issue price.

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The company records this adjustment to the cost as bond interest expense over the life of the
bonds through a process called amortization. Amortization of a discount increases bond
interest expense. Amortization of a premium decreases bond interest expense.
The required procedure for amortization of a discount or premium is the effective-interest
method (also called present value amortization). Under the effective-interest method,
companies:
1. Compute bond interest expense first by multiplying the carrying value (book value) of the
bonds at the beginning of the period by the effective-interest rate.
2. Determine the bond discount or premium amortization next by comparing the bond interest
expense with the interest (cash) to be paid.
Bond Discount and Premium Amortization Computation
The effective-interest method produces a periodic interest expense equal to a constant
percentage of the carrying value of the bonds.
Bonds Issued at a Discount
To illustrate amortization of a discount under the effective-interest method, assume Star Business
Group Company issued Br. 100,000 of 8 percent term bonds on January 1, 2022, due on January
1, 2027, with interest payable each July 1 and January 1. Because the investors required an
effective-interest rate of 10 percent, they paid Br. 92,278 for the Br. 100,000 of bonds, creating a
Br. 7,722 discount. Star Business Group computes the Br. 7,722 discount as shown below:
Maturity value of bonds payable Br. 100,000
Present value of Br. 100,000 due in 5 years at 10%,
interest payable semiannually; FV(PVF10,5%); (Br. 100,000 × .61391) Br.61,391
Present value of €4,000 interest payable semiannually for 5 years at 10%
Annually (PVF-OA10,5%); (Br. 4,000 × 7.72173) 30,887
Proceeds from sale of bonds (92,278)
Discount on bonds payable Br. 7,722
(Computation of Discount on Bonds Payable)

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Schedule of Interest payment and Bond Discount Amortization—Effective-Interest Method

8% Bonds Purchased to Yield 10%

Date Cash Interest Bond

Received Revenue Discount Carrying
Amortization Amount of Bonds
1/1/22 Br. 92,278
7/1/22 Br. 4,000a Br. 4,614b Br. 614c 92,892d
1/1/23 4,000 4,645 645 93,537
7/1/23 4,000 4,677 677 94,214
1/1/24 4,000 4,711 711 94,925
7/1/24 4,000 4,746 746 95,671
1/1/25 4,000 4,783 783 96,454
7/1/25 4,000 4,823 823 97,277
1/1/26 4,000 4,864 864 98,141
7/1/26 4,000 4,907 907 99,048
1/1/27 4,000 4,952 952 100,000
Br. 40,000 Br. 47,722 Br.7,722
aBr. 4,000 = Br.100, 000 × .08 × 6/12
bBr.4, 614 = Br. 92,278 × .10 × 6/12
cBr. 614 = Br.4, 614 – Br. 4,000
dBr.92, 892 = Br. 92,278 + Br. 614

Star Business Group records the issuance of its bonds at a discount on January 1, 2022, as
follows.
Cash 92,278
Bonds Payable 92,278
It records the first interest payment on July 1, 2022, and amortization of the discount as follows.
Interest Expense 4,614
Bonds Payable 614
Cash 4,000

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Star Business Group records the interest expense accrued at December 31, 2022 (year-end), and
amortization of the discount as follows.
Interest Expense 4,645
Interest Payable 4,000
Bonds Payable 645
Bonds Issued at a Premium
Now assume that for the bond issue described above, investors are willing to accept an effective
interest rate of 6 percent. In that case, they would pay Br. 108,530 or a premium of Br. 8,530,
computed as shown below:.
Maturity value of bonds payable Br.100, 000
Present value of €100,000 due in 5 years at 6%, interest payable
Semiannually FV(PVF10,3%); (Br. 100,000 × .74409) Br. 74,409
Present value of €4,000 interest payable semiannually for 5 years
at 6% annually (PVF-OA10,3%); (Br. 4,000 × 8.53020) 34,121
Proceeds from sale of bonds (108,530)
Premium on bonds payable Br. 8,530
(Computation of Premium on Bonds Payable)

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Schedule of Interest Payment and Bond Premium Amortization—Effective-Interest

Method 8% Bonds Purchased to Yield 6%
Date Cash Interest Bond
Received Revenue Premium Carrying
Amortization Amount of Bonds
1/1/22 Br. 108,530
7/1/22 Br. 4,000a Br. 3,256b Br. 744c 107,786d
1/1/23 4,000 4,766 766 107,020
7/1/23 4,000 4,789 789 106,231
1/1/24 4,000 4,813 813 105,418
7/1/24 4,000 4,837 837 104,581
1/1/25 4,000 4,863 863 103,718
7/1/25 4,000 4,888 888 102,830
1/1/26 4,000 4,915 915 101,915
7/1/26 4,000 4,943 943 100,972
1/1/27 4,000 4,972 972 100,000
Br. 40,000 Br. 48,530 Br.8, 530

aBr.4,000 = Br. 100,000 × .08 × 6⁄12

cBr. 744 = Br. 4,000 – Br. 3,256
bBr. 3,256 = Br. 108,530 × .06 × 6⁄12
dBr. 107,786 = Br. 108,530 – Br. 744
Star Business Group records the issuance of its bonds at a premium on January 1, 2022, as
follows:
Cash 108,530
Bonds Payable 108,530
Star Business Group records the first interest payment on July 1, 2022, and amortization of the
premium as follows:
Interest Expense 3,256
Bonds Payable 744
Cash 4,000

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Star Business Group should amortize the discount or premium as an adjustment to interest
expense over the life of the bond in such a way as to result in a constant rate of interest when
applied to the carrying amount of debt outstanding at the beginning of any given period.
Accruing Interest
In our previous examples, the interest payment dates and the date the financial statements were
issued were essentially the same. For example, when Star Business Group sold bonds at a
premium, the two interest payment dates coincided with the financial reporting dates. However,
what happens if Star Business Group prepares financial statements at the end of February, 2022?
In this case, the company prorates the premium by the appropriate number of months to arrive
at the proper interest expense.
Interest accrual (Br. 4,000 × 2/6) Br. 1,333.33
Premium amortized (Br. 744 × 2/6) (248.00)
Interest expense (Jan.–Feb.) Br. 1,085.33
(Computation of Interest Expense)
Star Business Group records this accrual as follows:
Interest Expense 1,085.33
Bonds Payable 248.00
Interest Payable 1,333.33
If the company prepares financial statements six months later, it follows the same procedure.
That is, the premium amortized would be as shown below:
Premium amortized (March–June) (Br. 744 × 4/6) Br. 496.00
Premium amortized (July–August) (Br. 766 × 2/6) 255.33
Premium amortized (March–August 2022) Br. 751.33
(Computation of Premium Amortization)
Bonds Issued Between Interest Dates
Companies usually make bond interest payments semiannually, on dates specified in the bond
indenture. When companies issue bonds on other than the interest payment dates, bond
investors will pay the issuer the interest accrued from the last interest payment date to the
date of issue. The bond investors, in effect, pay the bond issuer in advance for that portion of the
full six months’ interest payment to which they are not entitled because they have not held the

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bonds for that period. Then, on the next semiannual interest payment date, the bond
investors will receive the full six-month’ interest payment.
Bonds Issued at Par
To illustrate, assume that instead of issuing its bonds on January 1, 2022, Star Business Group
issued its five year bonds, dated January 1, 2022, on May 1, 2022, at par (Br. 100,000). Star
Business Group records the issuance of the bonds between interest dates as follows:
May 1, 2022
Cash 100,000
Bonds Payable 100,000
(To record issuance of bonds at par)
Cash 2,667
Interest Expense (Br. 100,000 × .08 × 4/12) 2,667
(To record accrued interest; Interest Payable might be credited instead)
Because Star Business Group issues the bonds between interest dates, it records the bond
issuance at par (Br. 100,000) plus accrued interest (Br. 2,667). That is, the total amount paid
by the bond investor includes four months of accrued interest.
On July 1, 2022, two months after the date of purchase, Star Business Group pays the investors
six months’ interest, by making the following entry.
Interest Expense
5/1/22 2,667a
7/1/22 4,000b
Balance 1,333
aAccrued interest received.
bCash paid.
July 1, 2022
Interest Expense (Br. 100,000 × .08 × 6/12) 4,000
Cash 4,000
(To record first interest payment)
The Interest Expense account now contains a debit balance of Br. 1,333 (Br. 4,000 – Br.2,667),
which represents the proper amount of interest expense—two months at 8 percent on Br.
100,000.

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Bonds Issued at Discount or Premium

The illustration above was simplified by having the January 1, 2022, bonds issued on May 1,
2022, at par. However, if the bonds are issued at a discount or premium between interest dates,
Star Business Group must not only account for the partial cash interest payment but also the
amount of effective amortization for the partial period.
To illustrate, assume that the Star Business Group 8-percent bonds were issued on May 1, 2022,
to yield 6 percent. Thus, the bonds are issued at a premium; in this case, the price is Br. 108,530
Star Business Group records the issuance of the bonds between interest dates as follows.
May 1, 2022
Cash 108,530
Bonds Payable 108,530
(To record the present value of the cash flows)
Cash 2,667
Interest Expense (Br. 100,000 × .08 × 4/12) 2,667
May 1, 2022
(To record accrued interest; Interest Payable might be credited instead)
In this case, Star Business Group receives a total of Br. 110,706 at issuance, comprised of the
bond price of Br. 108,039 plus the accrued interest of Br. 2,667. Following the effective-interest
procedures, Star Business Group then determines interest expense from the date of sale (May 1,
2022), not from the date of the bonds (January 1, 2022). Using the effective-interest rate of 6
Percent, the bond interest expense therefore for the two months (May and June) is Br. 1,080.
Interest Expense
Carrying value of bonds Br. 108,530
Effective-interest rate (.06 × 2/12) 1%
Interest expense for two months Br. 1,085
(Partial Period Interest Amortization)
The premium amortization of the bonds is also for only two months. It is computed by taking the
difference between the net cash paid related to bond interest and the effective-interest expense of
Br. 1,080. Using the effective interest rate of 6 percent, computation of partial amortization as
follows:
Cash interest paid on July 1, 2022 (Br. 100,000 × .08 × 6/12) Br. 4,000

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Less: Cash interest received on May 1, 2022 2,667

Net cash paid Br. 1,333
Bond interest expense (at the effective rate) for two months (1,085)
Premium amortization Br. 248
(Partial Period Interest Amortization)
As indicated, both the bond interest expense and amortization reflect the shorter two-month
period between the issue date and the first interest payment. Star Business Group therefore
makes the following entries on July 1, 2022, to record the interest payment and the premium
amortization.
Interest Expense
5/1/22 2,667a
7/1/22 4,000b 7/1/22 248c
Balance 1,085
aAccrued interest received.
bCash paid.
c2 months’ amortization.
July 1, 2022
Interest Expense 4,000
Cash 4,000
(To record first interest payment)
Bonds Payable 248
Interest Expense 248
(To record two months’ premium amortization)
The Interest Expense account now contains a debit balance of Br. 1,085 (Br. 4,000 – Br. 2,667 –
Br. 248), which represents the proper amount of interest expense—two months at an effective
annual interest rate of 6 percent on Br. 108,530.
5.2. Long-Term Notes Payable
The difference between current notes payable and long-term notes payable is the maturity date.
Short-term notes payable are those that companies expect to pay 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

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as readily as bonds in the organized public securities markets. Small companies commonly issue
notes as their long-term instruments. Larger companies issue both long-term notes and bonds.

Accounting for notes and bonds is quite similar. Like a bond, a note is valued at the present
value of its future interest and principal cash flows. The company amortizes any discount
or premium over the life of the note, just as it would the discount or premium on a bond.
Companies compute the present value of an interest-bearing note, record its issuance, and
amortize any discount or premium and accrual of interest in the same way that they do for bonds.
As you might expect, accounting for long-term notes payable parallels accounting for long-term
notes receivable.
Notes Issued at Face Value
The recognition of a Br. 10,000, three-year note Guna Imports issued at face value to Ambassel
Trading. In this transaction, the stated rate and the effective rate were both 10 percent. The time
for Ambassel would be the same for the issuer of the note, Guna Imports, in recognizing a note
payable. Because the present value of the note and its face value are the same, Br. 10,000, Guna
would recognize no premium or discount.
Guna Imports would recognize the interest incurred each year as follows.
Interest Expense (Br. 10,000 × .10) 1,000
Cash 1,000
(Notes Not Issued at Face Value)
Zero-Interest-Bearing Notes
If a company issues a zero-interest-bearing (non-interest-bearing) note solely for cash, it
measures the note’s present value by the cash received. The implicit interest rate is the rate that
equates the cash received with the amounts to be paid in the future. The issuing company
records the difference between the face amount and the present value (cash received) as a
discount and amortizes that amount to interest expense over the life of the note.
To illustrate the entries and the amortization schedule, assume that Mariamawit Company issued
the three-year, Br. 10,000, zero-interest-bearing note to Ermias Company. The implicit rate that
equated the total cash to be paid (Br. 10,000 at maturity) to the present value of the future cash
flows (Br. 7,721.80 cash proceeds at date of issuance) was 9 percent. (The present value of Br. 1
for three periods at 9 percent is Br. 0.77218.)

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Mariamawit Company records issuance of the note as follows.

Cash 7,721.80
Notes Payable 7,721.80
Mariamawit Company amortizes the discount and recognizes interest expense annually using the
effective interest method. The three-year discount amortization and interest expense schedule
shown below:
Schedule of Note Discount Amortization Effective-Interest Method 0% Note Discounted at
9%
Cash paid Interest expense Discount Carrying
amortized amount of notes
Date issued Br. 7,721.80
End of year 1 Br. 0 Br. 694.96a Br. 694.96b Br. 8,416.76c
End of year 2 Br. 0 757.51 757.51 Br. 9174.27
End of year 3 Br. 0 825.73 825.73 Br. 10,000
Br. 0 Br. 2,278.2 Br. 2,278.2

aBr. 7,721.80 × .09 = Br. 694.96 cBr. 7,721.80 + Br. 694.96 = Br. 8,416.76
bBr. 694.96 – Br. 0 = Br. 694.96 d5¢ adjustment to compensate for rounding
Mariamawit Company records interest expense at the end of the first year using the effective-
interest method as follows.
Interest Expense (Br. 7,721.80 × .09) 694.96
Notes Payable 694.96
The total amount of the discount, Br. 2,278.20 in this case, represents the expense that
Mariamawit Company will incur on the note over the three years.
Interest-Bearing Notes
The zero-interest-bearing note above is an example of the extreme difference between the stated
rate and the effective rate. In many cases, the difference between these rates is not so great.
Consider the example from AMA Co. issued for cash a Br. 10,000, three-year note bearing
interest at 10 percent to MMA Group. The market rate of interest for a note of similar risk is 12
percent. The effective rate of interest (12%) is greater than the stated rate (10%), the present

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value of the note is less than the face value. That is, the note is exchanged at a discount. AMA
Co. records the issuance of the note as follows.
Cash 9,520
Notes Payable 9,520
AMA Co. then amortizes the discount and recognizes interest expense annually using the
effective interest method. The three-year discount amortization and interest expense schedule
shown below.
Schedule of Note Discount Amortization Effective-Interest Method 10% Note Discounted
at 12%
Cash paid Interest expense Discount Carrying
amortized amount of notes
Date issued Br. 9,520
End of year 1 Br. 1,000 Br. 1,142 Br.142 9,662
End of year 2 Br. 1,000 1,159 159 9,821
End of year 3 Br. 1,000 1,179 179 10,000
Br. 3,000 Br. 3,480 Br. 480

aBr. 10,000 × .10 = Br. 1,000 cBr. 1,142 – Br. 1,000 = Br. 142
bBr. 9,520 × .12 = Br. 1,142 dBr. 9,520 + Br. 142 = Br. 9,662

AMA Co. records payment of the annual interest and amortization of the discount for the first
year as follows (amounts per amortization schedule).
Interest Expense 1,142
Notes Payable 142
Cash 1,000
When the present value exceeds the face value, AMA Co. issues the note at a premium. It does
so by recording the premium as a credit to Notes Payable and amortizing it using the effective-
interest method over the life of the note as annual reductions in the amount of interest expense
recognized.

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5.3. Extinguishment of Non-Current Liabilities

How do companies record the payment of non-current liabilities—often referred to as
extinguishment of debt? If a company holds the bonds (or any other form of debt security) to
maturity, the answer is straightforward: The Company does not compute any gains or losses. It
will have fully amortized any premium or discount at the date the bonds mature. As a result, the
carrying amount, the maturity (face) value, and the fair value of the bond are the same.
Therefore, no gain or loss exists.
In this section, we discuss extinguishment of debt under three common additional situations:
1. Extinguishment with cash before maturity.
2. Extinguishment by transferring assets or securities.
3. Extinguishment with modification of terms.
Extinguishment with Cash before Maturity
In some cases, a company extinguishes debt before its maturity date. The amount paid on
extinguishment or redemption before maturity, including any call premium and expense of
reacquisition, is called the reacquisition price. On any specified date, the carrying amount of
the bonds is the amount payable at maturity, adjusted for unamortized premium or discount. Any
excess of the net carrying amount over the reacquisition price is a gain from extinguishment.
The excess of the reacquisition price over the carrying amount is a loss from extinguishment.
At the time of reacquisition, the unamortized premium or discount must be amortized up to
the reacquisition date.
To illustrate, we use the Star Business Group bonds issued at a discount on January 1, 2022.
These bonds are due in five years. The bonds have a par value of Br. 100,000; a coupon rate of 8
percent paid semiannually, and were sold to yield 10%.

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Schedule of Interest payment and Bond Discount Amortization—Effective-Interest Method

8% Bonds Purchased to Yield 10%

Date Cash Interest Bond

Received Revenue Discount Carrying
Amortization Amount of Bonds
1/1/22 Br. 92,278
7/1/22 Br. 4,000a Br. 4,614b Br. 614c 92,892d
1/1/23 4,000 4,645 645 93,537
7/1/23 4,000 4,677 677 94,214
1/1/24 4,000 4,711 711 94,925
7/1/24 4,000 4,746 746 95,671
1/1/25 4,000 4,783 783 96,454
7/1/25 4,000 4,823 823 97,277
1/1/26 4,000 4,864 864 98,141
7/1/26 4,000 4,907 907 99,048
1/1/27 4,000 4,952 952 100,000
Br. 40,000 Br. 47,722 Br.7,722
aBr. 4,000 = Br.100, 000 × .08 × 6/12
bBr.4, 614 = Br. 92,278 × .10 × 6/12
cBr. 614 = Br.4, 614 – Br. 4,000
dBr.92, 892 = Br. 92,278 + Br. 614

Bond Premium Amortization Schedule, Bond Extinguishment

On January 1, 2024, two years after the issue date, Star Business Group calls the entire issue at
101 and cancels it. As indicated in the amortization schedule, the carrying value of the bonds on
January 1, 2024, is Br. 94,925. Star Business Group computes the loss on redemption
(extinguishment).
Reacquisition price (Br. 100,000 × 1.01) Br. 101,000
Carrying amount of bonds redeemed (94,925)
Loss on extinguishment Br. 6,075
(Computation of Loss on Redemption of Bonds)

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Star Business Group records the reacquisition and cancellation of the bonds as follows.
Bonds Payable 94,925
Loss on Extinguishment of Debt 6,075
Cash 101,000
Note that it is often advantageous for the issuer to acquire the entire outstanding bond issue and
replace it with a new bond issue bearing a lower rate of interest. The replacement of an existing
issuance with a new one is called refunding. Whether the early redemption or other
extinguishment of outstanding bonds is a non-refunding or a refunding situation, a company
should recognize the difference (gain or loss) between the reacquisition price and the carrying
amount of the redeemed bonds in income (in other income and expenses) of the period of
redemption.
Extinguishment by Exchanging Assets or Securities
In addition to using cash, settling a debt obligation can involve either a transfer of non-cash
assets (real estate, receivables, or other assets) or the issuance of the debtor’s shares. In these
situations, the creditor should account for the non-cash assets or equity interest received at
their fair value.
The debtor must determine the excess of the carrying amount of the payable over the fair value
of the assets or equity transferred (gain). The debtor recognizes a gain equal to the amount of the
excess. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that
the fair value of those assets differs from their carrying amount (book value).
Transfer of Assets
Assume that Awash Bank loaned Br. 20,000,000 to Goh Mortgage Company. Goh, in turn,
invested these in Ayat residential apartment buildings. However, because of low occupancy
rates, it cannot meet its loan obligations. Awash Bank agrees to accept real estate with a fair
value of Br. 16,000,000 from Goh Mortgage in full settlement of the Br. 20,000,000 loan
obligation. The real estate has a carrying value of Br. 21,000,000 on the books of Goh Mortgage.
Goh (debtor) records this transaction as follows.
Notes Payable (to Awash Bank) 20,000,000
Loss on Disposal of Real Estate (Br.21,000,000 − 16,000,000) 5,000,000
Real Estate 21,000,000
Gain on Extinguishment of Debt (20,000,000 − 16,000,000) 4,000,000

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Goh Mortgage has a loss on the disposition of real estate in the amount of Br. 5,000,000 (the
difference between the Br. 21,000,000 book value and the Br. 16,000,000 fair value). In addition,
it has a gain on settlement of debt of Br. 4,000,000 (the difference between the Br. 20,000,000
carrying amount of the note payable and the Br. 16,000,000 fair value of the real estate).
Granting of Equity Interest
Now assume that Awash Bank agrees to accept from Goh Mortgage 320,000 ordinary shares (Br.
10 par) that have a fair value of Br. 16,000,000, in full settlement of the Br.20,000,000 loan
obligation. Goh Mortgage (debtor) records this transaction as follows.
Notes Payable (to Awash Bank) 20,000,000
Share Capital—Ordinary (320,000 × Br.10) 3,200,000
Share Premium—Ordinary (Br.16,000,000 – 3,200,000) 12,800,000
Gain on Extinguishment of Debt 4,000,000
It records the ordinary shares issued in the normal manner. It records the difference between the
par value and the fair value of the shares as share premium.
Extinguishment with Modification of Terms
Practically every day, the Wall Street Journal or the Financial Times runs a story about some
company in financial difficulty. In many of these situations, a creditor may grant borrower
concessions with respect to settlement. The creditor offers these concessions to ensure the
highest possible collection on the loan. For example, a creditor may offer one or a combination
of the following modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.
As with other extinguishments, when a creditor grants favorable concessions on the terms of a
loan, the debtor has an economic gain. Thus, the accounting for modifications is similar to that
for other extinguishments. That is, the original obligation is extinguished, the new payable is
recorded at fair value, and a gain is recognized for the difference in the fair value of the new
obligation and the carrying value of the old obligation.
To illustrate, assume that on December 31, 2022, NBE enters into a debt modification agreement
with Resorts Development Group, which is experiencing financial difficulties.

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The bank restructures a Br. 10,500,000 loan receivable issued at par (interest paid to date) by:
Reducing the principal obligation from Br. 10,500,000 to Br. 9,000,000; extending the maturity
date from December 31, 2022, to December 31, 2026; and reducing the interest rate from the
historical effective rate of 12 percent to 8 percent. Given Resorts Development’s financial
distress, its market-based borrowing rate is 15 percent. IFRS requires the modification to be
accounted for as an extinguishment of the old note and issuance of the new note, measured at fair
value. Calculation of the fair value of the modified note, using Resorts Development’s market
discount rate of 15 percent.
Present value of restructured cash flows:
Present value of Br. 9,000,000 due in 4 years at 15%, interest payable annually;
FV(PVF4,15%); (Br. 9,000,000 × .57175) Br. 5,145,750
Present value of Br. 720,000* interest payable annually for 4 years at 15%;
R(PVF-OA4,15%); (Br. 720,000 × 2.85498) 2,055,586
Fair value of note Br. 7,201,336
* Br. 9,000,000 × .08
The gain on the modification is Br. 3,298,664, which is the difference between the prior carrying
value (Br. 10,500,000) and the fair value of the restructured note, as computed above (Br.
7,201,336).Given this information, Resorts Development makes the following entry to record the
modification.
Notes Payable (old) 10,500,000
Gain on Extinguishment of Debt 3,298,664
Notes Payable (new) 7,201,336
The amortization schedule for the new note, following the modification:
Date Cash paid Interest expense Amortization Carrying value
31/12/22 Br. 7,201,336
31/12/23 Br. 720,000a Br. 1,080,200b Br. 360,200c 7,561,536d
31/12/24 720,000 1,134,230 414,230 7,975,766
31/12/25 720,000 1,196,365 476,365 8,452,131
31/12/26 720,000 1,267,820 547,869 9,000,000
aBr. 9,000,000 × .08 cBr. 1,080,200 – Br. 720,000 eBr. 49 adjustments for rounding
bBr. 7,201,336 × .15 dBr.7,201,336 + Br.360,200

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Resorts Development recognizes interest expense on this note using the effective rate of 15
percent. Thus, on December 31, 2023 (date of first interest payment after restructure), Resorts
Development makes the following entry.
December 31, 2023
Interest Expense 1,080,200
Notes Payable 360,200
Cash 720,000
Resorts Development makes a similar entry (except for different amounts for credits to Notes
Payable and debits to Interest Expense) each year until maturity. At maturity, Resorts
Development makes the following entry.
December 31, 2026
Notes Payable 9,000,000
Cash 9,000,000
In summary, following the modification, Resorts Development has extinguished the old note
with an effective rate of 12 percent and now has a new loan with a much higher effective rate of
15 percent.

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