CHAPTER 13: CHAPTER

13:
Financial
Instruments:
Long-Term
Debt

Prepared by
Shannon Butler,
CPA, CA
Carleton
© 2017 MCGRAW-HILL EDUCATION LIMITED University
 Introduction
• Long-term debt is a significant source of financing for many
companies
• This chapter covers:
• Common sources of debt financing
• Technical elements of accounting for long-term debt;
issuance, interest measurement, and derecognition using
bonds payable as a base

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 Sources of Financing
Exhibit 13-1

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 Short-term Financing
•Trade credit from suppliers –
• “interest free”
• Promissory notes – obligate company to pay a supplier at or
before a given date – may bear interest or be non-interest
bearing

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 Short-term Financing
•Short-term bank loans –
• Operating lines of credit – finance working capital; may be
secured by charge on receivables and inventory
• Variable rates
• Limit set by percentage of collateral base
• Due on demand
• May be drawn as an “overdraft”

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 Short-term Financing
•Short term bank financing
•Large companies may issue commercial paper – short term
promissory notes sold in open market
• Settled through a financial intermediaries
•Sale or assignment of receivables to a financial institution

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 Long-term Financing
• Long-term loans – are appealing because:
• Short-term financing may not be available and cost may be
higher than long-term at the time;
• Causes no dilution of voting control or ownership;
• Debt capital is more easily obtained, especially for private
companies;
• Interest expense is tax deductible;
• Leverage used successfully can result in returns on
borrowed funds being higher than the cost of interest

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 Long-term Financing
• Leverage is risky because:
• Interest must be paid even if sales and profits are declining;
• Business failure may result if debt levels too high; and
• If financial difficulty, will have to restructure debt maturity
dates or interest rates.

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 Long-term Financing
• Debt is attractive for lender because:
• Provides legally enforceable debt payments;
• Principal is returned at maturity;
• Priority claim if corporation restructures debt or goes into
receivership or bankruptcy.

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 Long-term Financing
• Forms of long-term debt:
• Bank loans;
• Notes payable;
• Mortgages;
• Other asset-backed loans;
• Publicly issued bonds, secured or unsecured;
• Long-term leases.

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 Long-term Bank Financing
• Term loans – “medium term” loans – periods 1.5 to 5 years
• Requires collateral – equipment, land, buildings
• Secured on these tangible assets

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 Long-term Bank Financing
• Term loans - Repayment may be of two forms:
• Blended payments – interest rate is fixed and regular equal
annuity payments are made including princ and interest
• Principal portion of each payment reduces loan balance
• Designated monthly principal payments plus interest on
the outstanding balance
• Interest may be fixed or float – and paid at end of each
month based on outstanding balance
• Payment terms for principal may be monthly, quarterly,
annually, or lump sum “balloon payment”

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 Long-term Bank Financing
• Term loans
• Interest is accrued as time passes and is paid when due
• Shown as long-term on SFP
• Current portion is amount of principal due in the next 12
months

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 Long-term Bank Financing
• Long-Term bank financing loans
• Repayment terms more than 5 years;
• Include commercial mortgages and asset-backed financing

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 Long-term Bank Financing
• Commercial mortgages – secured on land and building
• Regular blended payments – designed to repay loan over
the initial amortization period
• Amortization period may be 25 years; but term is usually 5
years or less
• Fixed interest rate for the term; and is reset each new term
• May also have floating rate

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 Long-term Loans
• Other Sources of long-term financing
• Insurance companies or pension funds may provide
financing to larger companies

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 Long-term Loans
• Bonds Payable (debenture) – used to raise large amount of
of capital on a long-term basis:
• A bond - a formal agreement (bond indenture) to pay
principal and interest ;
• Bond indenture – specifies term, rights and duties of issuer
and bondholder.
• Restrictions on issuer; dollar amount authorized for
issuance; interest rate and payment dates; maturity date;
any conversion or call privileges

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 Debt Covenants
• Debt covenants – restrictions on corporation’s activities
• If broken – lender can demand repayment
• Accounting based covenants (maintenance tests)
• Maximum debt to equity ratio (or debt to asset ratio);
• Minimum current ratio; and
• Minimum interest coverage ratio.

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 Debt Covenants
• Debt covenants
• Behavioural – Restrictions on:
• Issuance of additional debt without permission;
• Dividend payments;
• Redemption or retirement of shares;
• Ability to pledge assets as security;
• Current management must remain in place;
• Transfer of control.

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Debt Issuance and Interest
Expense
• Bonds payable classification:
• are classified as “other financial liabilities”
• Initially recorded at fair value – cash received less
transaction costs – based on present value model
• Subsequently, amortized cost is used over its term

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Debt Issuance and Interest
Expense
• Bond valuation:
• Fair value - present value of all future cash flows using
effective interest rate (market yield rate)
• when effective rate = nominal rate – bonds is issued at par
or maturity amount
• When effective rate > nominal rate – bond value is at a
discount;
• When effective rate < nominal rate – bond value is at a
premium

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 Measurement of Interest
Expense
•Example:
•Issue bond Jan 1, 20X5 for $10,000 with a nominal (stated) interest rate of
3% and market rate of 8%. Interest is payable Dec 31 20X5 and 20X6, and
entire principal is due Dec 31,20X6.
• Present value of loan on Jan 1, 20X5:
Present value of $10,000 (P/F 8%,2) = $8,573
Present value of interest payments
10,000 X 3% (P/A, 8%,2) = 535
Present value of note at 8% $9,108

Dr. Cash 9,108

Dr. Discount on bonds payable 892
Cr. Bonds payable 10,000

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 Measurement of Interest
Expense

Date Interest Interest Discount Unamortized Net

payment expense amortization Discount Note
3% 8% Payable

Jan 1 20X5 892 9,108

Dec 31 20X5 300 729 429 463 9,537
Dec 31 20X6 300 763 463 0 10,000
Total 600 1,492 892

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 Measurement of Interest
Expense
Example continued using effective interest rate method:

December 31, 20X5 – interest using effective interest rate

$9,108 X 8% = 729

Dr. Interest expense 729

Cr. Discount on bonds payable 429
Cr. Cash 10,000 x 3% 300

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 Bonds Payable
•When interest payment dates are different from year end dates
• accrue interest from last interest payment date and bring
discount/premium amortization up to date
•When bonds issued between interest dates, accrued interest is
added to the price

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 Bonds Payable
•Assume in previous example – year end is November 30 20X5
• Accrue interest from Jan 1 20X5 to November 30
• 11 months accrual $729 x 11/12 = 668

Interest expense (729 x 11/12) 668

Interest payable (300 X 11/12) 275
Discount on bonds (429 x 11/12) 393

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 Bonds Payable
•Payment December 31 20X5

Interest expense (729 x 1/12) 61

Interest payable (300 X 11/12) 275
Discount on bonds (429 x 1/12) 36
Cash 300

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 Bonds Payable
•Bond Amortization
• The premium or discount can be unwound using straight-line
method - results in a constant dollar interest expense each
year
• Acceptable under ASPE
• Acceptable under IFRS if not materially different from the
effective interest rate method.

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 Debt Issue Costs
Debt issuance costs include:
• Upfront fees, legal, accounting, underwriting, commission,
engraving, printing, registration, and promotion costs
These costs paid by the issuer and reduce the net proceeds
from the bond issue, increasing the effective cost for the
issuer
• Amortize as part of effective interest expense

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 Debt Issue Costs
Example
Company issues a bond payable for $3 million and pays
underwriting fees of $220,000.
7 year 5% bond with annual interest payments
Bond sells at par –so company receives $3 million less
underwriting fees
• FV = $3 million
• PV = 3,000,000 – 220,000 = 2,780,000
• Pmt = 5% x $3million = $150,000
• N=7
• Interest = ? Interest = 6.33%

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 Debt Issue Costs
•Example continued

On issuance:
Cash 2,780,000
Deferred financing costs 220,000
Bond payable 3,000,000

At end of first year:

Interest expense (2,780,000 x 6.33% 175,974
Deferred financing costs 25,974
Cash 150,000

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 Foreign Exchange Issues

Many Canadian companies borrow from foreign lenders

• common source of non-Canadian financing is the U.S. banks,
other financial institutions and, for large public companies,
through the bond markets
• Additional foreign exchange risk

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 Accounting For Foreign
Currency-Denominated Debt
Report in the equivalent amount of reporting currency
(normally, Canadian dollars for Canadian companies) at the
spot rate on the report date
• The loan principal is translated into Canadian dollars on the
day it is borrowed at the current, or spot, exchange rate
• At every subsequent reporting date, the loan is re-
measured at the spot rate

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 Accounting For Foreign
Currency-Denominated Debt
•If exchange rates have changed, an exchange gain or loss
results
• reported in net income as it arises
•Interest expense – is accrued using the average exchange rate
for the period.

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 Accounting For Foreign
Currency-Denominated Debt
Example:
• Five year loan € 1,000,000 Jan 1, 20X5, at 5% interest
• Jan 1 20X5 spot rate €1 = $1.40
• Dec 31 20X5 spot rate €1 = $1.60

Jan 1 on issuance:
Cash 1,400,000
Long-term debt 1,400,000

Dec 31 year end – to adjust loan to $1,600,000

Exchange loss 200,000
Long-term debt 200,000

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 Accounting For Foreign
Currency-Denominated Debt
Example continued:
• For interest – the average spot rate for the year was €1 = $1.52
• Interest accrual for the year at the average spot rate
Dec 31 accrue interest: €1,000,000 x 5% x $1.52 =
Interest expense 76,000
Interest payable 76,000

Dec 31 year end – paid interest at spot rate

Interest payable 76,000
Exchange loss 4,000
Cash (€1,000,000 x 5% x $1.60) 80,000

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 Capitalization of Borrowing
Costs
When interest costs (borrowing costs) are directly attributable to
the acquisition, construction or production of a qualifying asset,
they must be capitalized as part of the cost of the asset
• Qualifying assets include: inventories, property, plant and
equipment and intangible assets.
• Only capitalized if the assets take a substantial amount of time
to get ready for intended use
For inventories at fair value (biological assets) or manufactured
in large quantities – choice to capitalize borrowing costs or not
• Depends on reporting objectives and circumstance

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 Capitalization of Borrowing
Costs
Borrowing costs includes interest (using effective rate), upfront
fees and foreign currency adjustments.
Capitalize borrowing costs:
• If a specific loan in place to finance the construction – then
interest costs incurred;
• If general borrowings used – determine average borrowing
rate and apply to the specific expenditures made for the
relevant time period

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 Capitalization of Borrowing
Costs

Capitalization begins when all three criteria are met:

• money is borrowed; and
• a payment is made on an asset; and
• activities begin to make the asset ready for use.
Capitalization ends when asset ready for use or if work is not
progressing

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 Debt Retirement
Derecognition or extinguishment – debt is removed from
accounts
Bonds retired at maturity are recorded by reducing the liability
and the asset given in repayment; no gain or loss arises

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 Debt Retirement
Bonds payable derecognition prior to maturity
May be purchased on open market for fair value
Redeemable bonds – borrower may pay back loan using a call
option that sets specific call price at a specific time
Retractable bonds – the investor may force repayment

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 Debt Retirement
Gain or loss results when bonds are derecognized for an
amount different than the amortized cost
Recording derecognition prior to maturity:
• Update interest expense to retirement date,
discount/premium amortization and related debt issue costs
• Remove discount/premium and loan payable accounts
• Record payment of cash or other consideration
• Record gain or loss

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 Debt Retirement

• Classification of gain or loss

• May be classified as unusual or ordinary on SCI
• May be deferred and amortized if new “replacement” debt
is a substitution or modification of old debt

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Exhibit 13-6
Debt Retirement

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 Defeasance
Extinguishment of debt may be accomplished by defeasance -
requires company to place assets in an irrevocable trust sufficient
to pay the debt interest and principal
Creditor has approved this, and company no longer has obligation
to creditor
Therefore can derecognize the liability
• with an entry that removes the assets (funding), liability, and
related accounts, and records a gain or loss

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 In-Substance Defeasance

In-substance defeasance is similar to defeasance, except that

the trust is not irrevocable
Creditor has not approved and therefore the company still has
an obligation
Liability is not removed from the balance sheet and a
separate investment account is recorded for funds transferred
to the trustee.

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Substitution of Modification of
Debt
Substitution or modification of debt - repay and reborrow in
the same transaction, replacing an existing loan prior to its due
date
If present value of new loan is at least 10% different from the
present value of old loan, then
• extinguish the old loan recognizing gain or loss and record
the new loan
If difference is less than 10%, then, in substance, there is no
difference, and no gain or loss is recorded

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 Statement of Cash Flows
•Financing section include:
• Cash inflow from issuance of bonds
• Cash outflow to repay bonds
•Operating section includes (assuming indirect method):
• Loss (gain) on bond retirement is added back (deducted)
• Discount or premium amortization is added back
• Interest expense is added back

•Interest paid may be shown as a financing or operating

activity.

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 Disclosures for Long-Term
Liabilities
• Accounting policies, fair values and methods used to
determine fair values
• Title, interest rate, interest expense, maturity date, amount
outstanding, security, redemption or conversion privileges
• Aggregate amount of payments due in next five years
• Foreign currency
• Show secured liabilities separately and the fact they are
secured
• Details of defaults
• Objectives, policies and processes to manage risk and capital

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 Accounting Standards for
Private Enterprises
• Treatment of long-term liabilities is similar under IFRS and
ASPE
• May use either the effective interest method or the straight-
line method
• May choose to capitalize borrowing costs, but no guidelines
are provided – disclose accounting policy
• Disclosure is less extensive under ASPE

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 Accounting Standards for
Private Enterprises
Exhibit 13-9 Comparison of straight-line and effective interest amortization

Calculations Effective Interest Straight-line

Calculation of interest Effective rate x Net Cash paid + discount
expense carrying value of bond amortization or –
premium amortization
Calculation of discount Difference between cash Discount or
or premium paid and expense premium/period that
amortization bond is outstanding
Patterns
Annual interest expense Changes in year Constant over term
Annual interest expense Constant over term Changes each year
as % of beginning book
value (interest rate)

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 END OF CHAPTER 13:
Financial Instruments:
Long-Term Debt
Summary  Debt financing introduces financial leverage in a
company’s capital structure, and increases financial risk. Short-
term financing is available through trade credit, promissory
notes, and short-term bank loans of various kinds. Long-term
financing can be sourced through financial institutions or capital
markets. Common loan vehicles are term loans, commercial
mortgages, and bonds. Long-term debt often involves debt
covenants to provide reassurance and recourse to lenders.
Covenants include accounting-based covenants and restricted
actions. Long-term debt is usually classified as a financial
liability, in the other financial liabilities category, and is carried at
amortized cost.
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