C ONCEPTUAL E VALUATION OF A CCOUNTING FOR T ROUBLED D EBT R ESTRUCTURINGS
WhenFASB Statement No. 15was issued, many accountants and financial statement users criticized the accounting principles for the modification of terms for a troubled debt restructuring. With the issuance of FASB Statement No. 114, these criticisms apply only to the accounting by the debtor because there is no longer a mirror image between the debtor and creditor, as we discussed earlier. The critics argue that the procedures for the debtor (i.e., a limited or no gain) lead to inconsistencies in recording events that have similar economic substance (i.e., a modification of terms and an asset or equity exchange). They view a modification of terms as an economic event that should be recorded at a present value. In other words, they argue that the debtor should follow the procedures that are now required for the creditor. However, as we discussed earlier in the chapter for loan impairment, the Statementwas adopted by a 5-to-2 vote with the two dis- senters arguing that the fair value of the loan should be recognized.
At the time that FASB Statement No. 15was issued, it was widely believed that the rules to be followed by the creditor in a modification of terms were the result of lobbying by financial institutions. These institutions argued that the recognition of large losses under the fair value approach would undermine the public’s confidence in the banking system and have an adverse effect on the economy. A counterargument was that the non- recognition of losses enabled banks to continue in business longer than they should have, resulting in larger payments by taxpayers to “bail out” failing banks.
Since these original rules for the creditor have now been superseded, it seems logical that the rules for the debtor should also be modified. However, some supporters of the orig- inal rules point out that the FASB was just being conservative in its approach so as to mini- mize the gain recognized by a financially distressed debtor in a restructuring. Therefore, the choice of the accounting principle for debtors is based on whether a person believes that conservatism or the recognition of fair value is more important to external decision makers.
A PPENDIX 2: S ERIAL B ONDS
In the main part of this chapter, we focused on accounting for bonds in which the entire face value was due on one maturity date. Bonds also may contain provisions that require the issuer to repay the face value in periodic installments over a number of years;these bonds are termed serial bonds.Serial bonds may be especially attractive in cases where the bond issue is used to finance a particular project, because the issuer can use the yearly cash flow from that project to retire the bond issue.
R ECORDING THE I SSUANCE AND I NTEREST E XPENSE OF S ERIAL B ONDS
Serial bonds may sell at a premium or discount because of differences between the pre- vailing market rate and the stated rate of interest. Since the bonds mature over a number of periods and interest rates depend partly on the terms of the issue, some accountants have questioned the use of a single interest rate to record the initial issue of serial bonds. There are, however, no generally accepted principles for determining the different interest rates to assign to each individual installment. So it is assumed that they all yield the same rate of interest. Thus, a company records the initial issuance of serial bonds in the same manner as other bonds. That is, it records the entire face value in a Bonds Payable account and any discount or premium in a separate contra or adjunct account. After issuance, it computes interest expense and any premium or discount amortization on serial bonds by the effective interest method.Alternatively, it may use a method similar to the straight-line method, known as the bonds outstanding method.This method results in recording an amount of discount or premium amortization proportionate to the face value of the bonds outstanding. Under this method, if $400,000 of 13% serial bonds are to be repaid
13 Account for serial bonds.
Conceptual
A R
in four $100,000 installments, a proportionate (fractional) share of any premium or dis- count is amortized over the number of periods each installment is outstanding. The denominator of this fraction is derived by summing the face values of the bonds outstand- ing at the beginningof each period over the life of the entire issue. The numerator of this fraction is the face value of bonds outstanding at the beginningof each period.
Example: Serial Bonds
To illustrate these two methods, assume that the Wallace Corporation issues $400,000 of serial bonds with a 13% stated rate of interest for $410,460.92 on January 1, 2005. The company is to repay the bonds in four semiannual $100,000 installments beginning June 30, 2007 and to pay interest semiannually. The $410,460.92 selling price of this serial bond issue reflects a yield of 12%, as we show in the following calculations using factors from the Time Value of Money Module:
The company records the issuance as follows:
Cash 410,460.92
Bonds Payable 400,000.00
Premium on Bonds Payable 10,460.92
Example 14-7 shows the use of the bonds outstanding (straight-line) method of amortization for these serial bonds. Example 14-8 shows the use of the effective interest method for the same bonds.
In both Examples 14-7 and 14-8, the interest expense debit column shows the interest that Wallace records for each period. The interest expense for the semiannual periods in 2007 and 2008 decreases because the company makes partial repayments during these periods. The cash credit column during these periods also reflects these repayments. For example, on December 31, 2007, the company records the interest expense and partial retirement of the bonds (using straight-line amortization) as follows:
Bonds Payable 100,000.00
Premium on Bonds Payable 1,207.03
Interest Expense 18,292.97
Cash 119,500.00♦
685Recording the Issuance and Interest Expense of SerialBonds Interest Expense and Premium Amortization Schedule for Serial Bonds: Straight-Line (Bonds Outstanding) Method
EXAMPLE 14-7
Interest Expense and Premium Amortization Schedule for Serial Bonds:
Effective Interest Method: 13% Bonds Sold to Yield 12%
EXAMPLE 14-8