CHAPTER TWO

Non-Current Liabilities
2.1 Nature and classification of non-Current Liabilities

Non-current liabilities are also known as long-term liabilities or long-term debts (LTDs, 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.

2.1.1 Nature, Terminology and types of Bonds

2.2.1 Nature of Bonds
 A bond is an ‘‘IOU’’ (I owe you) in which an investor agrees to loan money to a company or
government in exchange for a predetermined interest rate. A bond is simply a form of an interest-
bearing note. Like a note, a bond requires periodic interest payments, and the face amount must
be repaid at the maturity date.
 Bonds are a form of interest-bearing notes payable issued by corporations, governments, and
governmental agencies.
 A bond indenture also called trust indenture defines the rights of the bondholders.
Trustee is a third party protecting the interests of both the borrower and the bondholders.
 Bonds, like common shares, can be sold in small denominations (usually a thousand dollars),
and as a result they attract investors.

2.1.2 Bond Terminology

1. The face (or par) value is the amount that the issuer agrees to pay at maturity.
2. Stated, coupon, or nominal rate is the interest rate written in the terms of the bond
indenture (and often printed on the bond certificate). The issuer of the bonds sets this rate.
3. The yield (effective rate) is the market rate at which the bonds are actually sold.
4. Bond certificate provides written evidence of borrowing company’s obligation to repay
lender for principal borrowed plus accumulated interest
2.1.3 Types of Bonds
We define some of the more common types of bonds found in practice as follows.

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 1
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.
Term, Serial Bonds, and Callable Bonds.

 Bond issues that mature on a single date are called term bonds.
 Bond 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.
 Convertible Bonds. If bonds are convertible into other securities of the company for a
specified time after issuance, they are convertible bonds.
Registered and Bearer
 Registered bonds are issued in the name of the owner and have interest payments made by
cheque to bondholders of record.
 Bearer or coupon bonds are not registered; thus bondholders must send in coupons to receive
interest payments.
Revenue and Income
 Revenue bonds pay interest only from specified revenue sources.
 Income bonds pay no interest unless the issuing company is profitable.
2.1.4 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 $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 $100, $1,000, or $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.

2.2 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

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 2
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 time 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.
How do you calculate the amount of interest that is actually paid to the bondholder each period?

(Stated rate x Face Value of the bond)

How do you calculate the amount of interest that is actually recorded as interest expense by the
issuer of the bonds?

(Market rate x Carrying Value of the bond)

 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).
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.

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 3
Bonds Issued at Par

To illustrate the computation of the present value of a bond issue, assume that Santos SA issues
$100,000 in bonds dated January 1, 2022, due in five years with 9 percent interest payable
annually on January 1. At the time of issue, the market rate for such bonds is 9 percent.
The time diagram in Illustration 14.1 depicts both the interest and the principal cash flows
The actual principal and interest cash flows are discounted at a 9 percent rate for five periods, as

Bond Value = present value of principal + PV of ordinary annuity interest

[ ]
1
1−

BV = FV (1+i) –n +
( 1+i )n
i
= PMT [
1− ( 1 + i )−n
i ]
Present value of the principal:
$100,000 × .64993 $ 64,993
Present value of the interest payments:
$9,000 × 3.88965 35,007
Present value (selling price) of the bonds $100,000

Santos makes the following entries in the first year of the bonds.

Bonds Issued at Discount

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 4
To illustrate, assume now that Santos issues $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.

Present value of the principal:

$100,000 × .59345 $59,345
Present value of the interest payments:
$9,000 × 3.69590 33,263
Present value (selling price) of the bonds $92,608
These bonds would sell at a discount of $7,392 ($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 Santos bonds sold for 92.6 (92.6% of par). If Santos had received
R$102,000, then the bonds sold for 102 (102% of par).

Journal entry on date of issue jan1 2022

Cash $92,608
Bond Payable $92,608
Journal entry to record accrued interest at Dec 31, 2022
Interest expense ($92,608*0.11) 10,187
Interest Payable 9,000
Bond Payable 1,187
Journal entry to record first payment on Jan 1, 2023
Interest Payable 9,000
Cash 9,000
Bonds Issued at Premium
Illustration: assuming now that Santos issues $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 6 percent.

Present value of the principal:

$100,000 × 0.747258 $74,726
Present value of the interest payments:
$9,000 × 4.21236 $37,911
Present value (selling price) of the bonds $112,637
Journal entry on date of issue jan1 2022
Cash $112,637
Bond Payable $112,637
Journal entry to record accrued interest at Dec 31, 2022
Interest expense ($112,637*6%) 6758.22

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 5
Bond Payable 2241.78
Interest Payable 9,000
Journal entry to record first payment on Jan 1, 2023
Interest Payable 9,000
Cash 9,000
Effective-Interest Method
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.

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).

The computation of the amortization is:-

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

Illustration: Evermaster corporation issued $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 $92,278 for the $100,000 of
bonds, creating a $7,722 discount.

Maturity value of bonds payable $100,000

Present value of $100,000 due in 5 years at 10%, interest payable
semiannually ; FV(PVF10,5%); ($100,000 × .61391) $61,391
Present value of $4,000 interest payable semiannually for 5 years at 10%
annually; R(PVF-OA10,5%); ($4,000 × 7.72173) 30,887
Proceeds from sale of bonds (92,278)
Discount on bonds payable $ 7,722

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 6
 Schedule of Bond Discount Amortization Effective-Interest
Method—Semiannual Interest Payments
5-Year, 8% Bonds Sold to Yield 10%
Carrying
Cash Interest Discount Amount of
Date Paid Expense Amortized Bonds
1/1/22 $ 92,278
7/1/22 $ 4,000 a
$ 4,614b
$ 614 c
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
$40,000 $47,722 $7,722
a$4,000 = $100,000 × .08 × 6/ c$614 = $4,614 − $4,000
12
b$4,614 = $92,278 × .10 × 6/ d$92,892 = $92,278 + $614
12

Journal entry on date of issue jan1 2022

Cash 92,278
Bonds Payable 92,278
Journal entry to record first payment amortization of the discount on July 1, 2022

Interest Expense 4,614

Bonds Payable 614
Cash 4000

Journal entry to record accrued interest and amortization of the discount at Dec 31, 2022

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 $108,530 or a premium of $8,530

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 7
 Schedule of Bond Premium Amortization
Effective-Interest Method—Semiannual Interest Payments
5-Year, 8% Bonds Sold to Yield 6%
Carrying
Cash Interest Premium Amount
Date Paid Expense Amortized of Bonds
1/1/22 $108,530
7/1/22 $ 4,000 a
$ 3,256 b
$ 744 c
107,786d
1/1/23 4,000 3,234 766 107,020
7/1/23 4,000 3,211 789 106,231
1/1/24 4,000 3,187 813 105,418
7/1/24 4,000 3,163 837 104,581
1/1/25 4,000 3,137 863 103,718
7/1/25 4,000 3,112 888 102,830
1/1/26 4,000 3,085 915 101,915
7/1/26 4,000 3,057 943 100,972
1/1/27 4,000 3,029 972 100,000
$40,000 $31,471 $8,529*
a c
$4,000 = $100,000 × .08 × 6/12 $744 = $4,000 − $3,256
b d
$3,256 = $108,530 × .06 × 6/12 $107,786 = $108,530 − $744
*Rounded

Journal entry on date of issue jan1 2022

Cash 108,530
Bonds Payable 108,530
Journal entry to record first payment and amortization of the premium July 1, 2022
Interest Expense 3,256
Bonds Payable 744
Cash 4,000
Evermaster 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.

Bonds Issued Between Interest Date

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
bonds for that period. Then, on the next semiannual interest payment date, the bond
investors will receive the full six-months’ interest payment.

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 8
 Bonds Issued at Par
To illustrate, assume that instead of issuing its bonds on January 1, 2022, Evermaster issued its
five- year bonds, dated January 1, 2022, on May 1, 2022, at par ($100,000). Evermaster 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
4
Interest Expense ($100,000 × .08 × /12) 2,667
(To record accrued interest; Interest Payable might be credited instead)
Because Evermaster issues the bonds between interest dates, it records the bond issuance at par
($100,000) plus accrued interest ($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, Evermaster pays the investors six
months’ interest, by making the following entry.

July 1, 2022
Interest Expense ($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 $1,333 ($4,000 − $2,667), which
represents the proper amount of interest expense—two months at 8 percent on $100,000.

Bonds Issued at Premium

If the bonds are issued at a discount or premium between interest dates, Evermaster 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 Evermaster 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 $108,039.
Evermaster records the issuance of the bonds between interest dates as follows.

May 1, 2022
Cash 108,039
Bonds Payable 108,039
(To record the present value of the cash flows)
Cash 2,667
Interest Expense ($100,000 × .08 × /12)4
2,667
May 1, 2022
(To record accrued interest; Interest Payable might be credited instead)

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 9
In this case, Evermaster receives a total of $110,706 at issuance, comprised of the bond price of
$108,039 plus the accrued interest of $2,667. Following the effective-interest procedures,
Evermaster then determines interest expense from the date of sale (May 1, 2022), not from the
date of the bonds (January 1, 2022).
The bond interest expense therefore for the two months (May and June) is $1,080.

Interest Expense
Carrying value of bonds $108,039
2
Effective-interest rate (.06 × /12) 1%
Interest expense for two months $ 1,080
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
$1,080.

Cash interest paid on July 1, 2022 ($100,000 × .08 × 6/12) $4,000

Less: Cash interest received on May 1, 2022 2,667
Net cash paid $1,333
Bond interest expense (at the effective rate) for two months (1,080)
Premium amortization $ 253
As indicated, both the bond interest expense and amortization reflect the shorter two-month
period between the issue date and the first interest payment. Evermaster therefore makes the
following entries on July 1, 2022, to record the interest payment and the premium amortization.

July 1, 2022
Interest Expense 4,000
Cash 4,000
(To record first interest payment)
Bonds Payable 253
Interest Expense 253
(To record two months’ premium amortization)
The Interest Expense account now contains a debit balance of $1,080 ($4,000 − $2,667 − $253),
which represents the proper amount of interest expense—two months at an effective annual
interest rate of 6 percent on $108,039.

2.3 Extinguishment of Non-Current Liabilities

Bonds typically retired (paid off) at maturity date. Some bonds may be redeemed by the issuing
company prior to their maturity date. 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.

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 10
2.3.1 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.
Whether bonds are recalled, retired, or refunded prior to maturity, any gain or loss is reported as
a component of income from continuing operations in the current period.
 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..
Illustration: Evermaster bonds issued at a discount on January 1, 2022. These bonds are due in
five years. The bonds have a par value of $100,000, a coupon rate of 8 percent paid
semiannually, and were sold to yield 10 percent. On January 1, 2024, two years after the issue
date, Evermaster calls the entire issue at 101 and cancels it.
The amortization schedule for the Evermaster bonds is presented below

Schedule of Bond Discount Amortization

Effective-Interest Method—Semiannual Interest Payments
5-Year, 8% Bonds Sold to Yield 10%
Carrying
Cash Interest Discount Amount
Date Paid Expense Amortized of Bonds
1/1/22 $ 92,278
7/1/22 $ 4,000 a
$ 4,614b
$ 614 c
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
$40,000 $47,722 $7,722
a c
$4,000 = $100,000 × .08 × 6/12 $614 = $4,614 − $4,000
b 6 d
$4,614 = $92,278 × .10 × /12 $92,892 = $92,278 + $614

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 11
As indicated in the amortization schedule, the carrying value of the bonds on January 1, 2024, is
$94,925.

Required;- A. Compute the loss on extinguishment, if any.

Reacquisition price ($100,000 × 1.01) $101,000

Carrying amount of bonds redeemed (94,925)
Loss on extinguishment $ 6,075

B. Record the reacquisition and cancelation of the bonds.

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.
2.3.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 Hamburg Bank loaned $20,000,000 to Bonn Mortgage Company. Bonn, in
turn, invested these monies in residential apartment buildings. However, because of low
occupancy rates, it cannot meet its loan obligations. Hamburg Bank agrees to accept real estate
with a fair value of $16,000,000 from Bonn Mortgage in full settlement of the $20,000,000
loan obligation. The real estate has a carrying value of $21,000,000 on the books of Bonn
Mortgage. Bonn (debtor) records this transaction as follows.

Notes Payable (to Hamburg Bank) 20,000,000

Loss on Disposal of Real Estate ($21,000,000 − $16,000,000) 5,000,000
Real Estate 21,000,000

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 12
 Gain on Extinguishment of Debt ($20,000,000 − $16,000,000) 4,000,000
Bonn Mortgage has a loss on the disposition of real estate in the amount of $5,000,000 (the
difference between the $21,000,000 book value and the $16,000,000 fair value). In addition, it
has a gain on settlement of debt of $4,000,000 (the difference between the $20,000,000
carrying amount of the note payable and the $16,000,000 fair value of the real estate).

Granting of Equity Interest

Now assume that Hamburg Bank agrees to accept from Bonn Mortgage 320,000 ordinary
shares ($10 par) that have a fair value of $16,000,000, in full settlement of the $20,000,000
loan obligation. Bonn Mortgage (debtor) records this transaction as follows.

Notes Payable (to Hamburg Bank) 20,000,000

Share Capital—Ordinary (320,000 × $10) 3,200,000
Share Premium—Ordinary ($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.

,Prepared By: Endris Y. (MSc), ACFN, in Mekdela Amba university, 2016 E.C Page 13