Notes and Bonds

Notes represent debt issued to a single investor without intending for the debt to be broken up among many investors. Their maturity, usually lasting one to seven years, tends to be shorter than that of a bond. Bonds also result from a single agreement. However, a bond is intended to be broken up into various subunits, typically $1,000 each, which can be issued to a variety of investors.

Notes and bonds share common characteristics. These include a written agreement stating the amount of the principal, the interest rate, when the interest and principal are to be paid, and the restrictive covenants, if any, which must be met.

The interest rate is affected by many factors, including the cost of money, the organization risk factors, and the inflationary expectations associated with the organization.

The stated rate on a note or bond often differs from the market rate at the time of issuance. When this occurs, the present value of the interest and principal payments will differ from the maturity, or face value. If the market rate exceeds the stated rate, the cash proceeds will be less than the face value of the debt because the present value of the total interest and principal payments discounted back to the present yields an amount that is less than the face value. Because an investor is rarely willing to pay more than the present value, the bonds must be issued at a discount. The discount is the difference between the issuance price (present value) and the face, or stated, value of the bonds. This discount is then amortized over the life of the bonds to increase the recognized interest expense so that the total amount of the expense represents the actual bond yield.

When the stated rate exceeds the market rate, the bond will sell for more than its face value (at a premium) to bring the effective rate to the market rate and will decrease the total interest expense. When the market and stated rates are equivalent at the time of issuance, no discount or premium exists and the instrument will sell at its face value. Changes in the market rate subsequent to issuance are irrelevant in determining the discount or premium or their amortization.

Notes are a common form of exchange in business transactions for cash, property, goods, and services. Notes are sometimes used by not-for-profit organizations to obtain financing from donors/investors. The donor/investor typically buys a note from a not-for-profit organization at a reasonable, but somewhat lower, interest rate than if the donor/investor were purchasing the note strictly on the basis of the creditworthiness of an organization. Not-for-profit organizations also use bonds and notes when constructing or purchasing significant new buildings or facilities. Most notes carry a stated rate of interest, but it is not uncommon for noninterest notes, or notes bearing an unrealistic rate of interest, to be exchanged. Notes such as these, which are long-term in nature, do not reflect the economic substance of the transaction since the face value of the note does not represent the present value of the consideration involved. Not recording the note at its present value will misstate the cost of the asset or services to the buyer as well as the selling price and profit to the seller. In subsequent periods, both the interest expense and revenue will be misstated.

To remedy the situation, GAAP includes guidance at FASB ASC 835-30. All commitments to pay (and receive) money at a determinable future date are subject to present value techniques and, if necessary, interest imputation with the exception of the following:

1. Normal accounts payable due within one year.
2. Amounts to be applied to purchase price of goods or services or that provide security to an agreement (e.g., advances, progress payments, security deposits, and retainages).
3. Transactions between parent and subsidiary.
4. Obligations payable at some indeterminable future date (warranties).
5. Transactions where interest rates are affected by prescriptions of a governmental agency (e.g., revenue bonds, tax exempt obligations, etc.).

Notes issued solely for cash. When a note is issued solely for cash, its present value is assumed to be equal to the cash proceeds. The interest rate is that rate which equates the cash proceeds to the amounts to be paid in the future (i.e., no interest rate is to be imputed). For example, a $1,000 note due in three years that sells for $889 has an implicit rate of 4% ($1,000 × 0.889, where 0.889 is the present value factor of a lump sum at 4% for three years). This rate is to be used when amortizing the discount.

Noncash transactions. When a note is issued for consideration such as property, goods, or services, and the transaction is entered into at arm's length, the stated interest rate is presumed to be fair unless (1) no interest rate is stated, (2) the stated rate is unreasonable, or (3) the face value of the debt is materially different from the consideration involved or the current market value of the note at the date of the transaction. When the rate on the note is not considered fair, the note is to be recorded at the “fair market value of the property, goods, or services received or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable.” When this amount differs from the face value of the note, the difference is to be recorded as a discount or premium and amortized to interest expense.

If the fair market value of the consideration or note is not determinable, then the ­present value of the note must be determined using an imputed interest rate. This rate will then be used to establish the present value of the note by discounting all future payments on the note at this rate. General guidelines for imputing the interest rate, which are provided at FASB ASC 835-30-25, include the prevailing rates of similar instruments from creditors with ­similar credit ratings and the rate the debtor could obtain for similar financing from other sources. Other determining factors include any collateral or restrictive covenants involved, the current and expected prime rate, and other terms pertaining to the instrument. The objective is to approximate the rate of interest that would have resulted if an independent borrower and lender had negotiated a similar transaction under comparable terms and conditions. This determination is as of the issuance date, and any subsequent changes in interest rates would be irrelevant.

Bonds represent a promise to pay a sum of money at a designated maturity date plus periodic interest payments at a stated rate. Bonds are primarily used to borrow funds from the general public or institutional investors when a contract for a single amount (a note) is too large for any one lender to supply. Dividing up the amount needed into $1,000 or $10,000 units makes it easier to sell the bonds.

In most situations, a bond is issued at a price other than its face value. The amount of the cash exchanged is equal to the total of the present value of the interest and principal payments. The difference between the cash proceeds and the face value is recorded as a premium if the cash proceeds are greater, or as a discount if they are less. The journal entry to record a bond issued at a premium follows:

The premium will be recognized over the life of the bond issue. If issued at a discount, “Discount on bonds payable” would be debited for the difference. As the premium is amortized, it will reduce interest expense on the books of the issuer (a discount will increase interest expense). The premium (discount) would be added to (deducted from) the related liability when a statement of financial position is prepared.

The effective interest method is the preferred method of accounting for a discount or premium arising from a note or bond, although some other method may be used (e.g., straight-line) if the results are not materially different. While APB 21 only mandated that the effective interest method be used on notes covered by that opinion, the profession has made the use of the effective interest method the only acceptable one. Under the effective interest method, the discount or premium is to be amortized over the life of the debt in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. Therefore, interest expense is equal to the market rate of interest at the time of issuance multiplied by this beginning figure. The difference between the interest expense and the cash paid represents the amortization of the discount or premium.

Interest expense under the straight-line method is equal to the cash interest paid plus the amortized portion of the discount or minus the amortized portion of the premium. The amortized portion is equal to the total amount of the discount or premium divided by the life of the debt from issuance in months multiplied by the number of months the debt has been outstanding that year.

Amortization tables are often created at the time of the bond's issuance to provide figures when recording the necessary entries relating to the debt issue. They also provide a check of accuracy since the final values in the unamortized discount or premium and carrying value columns should be equal to zero and the bond's face value, respectively.

When the interest date does not coincide with the year-end, an adjusting entry must be made. The proportional share of interest payable should be recognized along with the amortization of the discount or premium. Within the amortization period, the discount or premium should be amortized using the straight-line method.

If the bonds are issued between interest dates, discount or premium amortization must be computed for the period between the sale date and the next interest date. This is accomplished by “straight-lining” the period's amount calculated using the usual method of amortization. In addition, the purchaser prepays the seller the amount of interest that has accrued since the last interest date. This interest is recorded as a payable (or as a credit to interest expense) by the seller. At the next interest date, the buyer then receives the full amount of interest regardless of how long the bond has been held. This procedure results in interest being paid equivalent to the time the bond has been outstanding.

Costs may be incurred in connection with issuing bonds. Examples include legal, accounting, and underwriting fees; commissions; and engraving, printing, and registration costs. Although these costs should be classified as a deferred charge and amortized using the effective interest method, generally the amount involved is such that use of the simpler straight-line method would not result in a material difference.

The diagram below illustrates the accounting treatments for monetary assets (and liabilities) as prescribed at FASB ASC 835-30.

NOTE: In April 2015, the FASB issued ASU 2015-03 Interest—Imputation of Interest (Subtopic 835-30) Simplifying the Presentation of Debt Issuance Costs. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct reduction from the carrying amount of that debt liability, consistent with debt discounts. ASU 2015-03 does not change the recognition and measurement guidance for debt issuance costs.

ASU 2015-03 is effective for not-for-profit organizations for fiscal years beginning after December 15, 2015. Early adoption is permitted for financial statements that have not been previously issued. This new guidance should be applied on a retrospective basis.

Extinguishment of Debt

FASB ASC 405-20 provides accounting and reporting standards for extinguishments of liabilities. The situation where an in-substance defeasance of debt resulted in the liability being removed from the statement of financial position in the past is effectively eliminated.

In a transfer of financial assets, any resulting liabilities or derivatives are to be measured initially at fair value. A servicing liability is to be amortized in proportion to and over the period of estimated net servicing loss or net servicing income. It should be assessed for increased obligation based on fair value.

In-substance defeasance does not result in the extinguishment of a liability. Except for debt conversions and troubled debt restructurings, a liability is derecognized only if:

1. The creditor is paid and the debtor is relieved of the obligation;
2. The debtor is released legally either by the creditor or judicially from being the primary obligor.

Disclosure is required for in-substance defeased debt extinguished under prior accounting rules. The amount extinguished at the end of the period and a general description of the transaction must be given as long as the debt is outstanding. The nature of any restrictions on assets set aside for making scheduled payments for specific liabilities must be disclosed.

If a debtor becomes secondarily liable, through a third-party assumption and a release by the creditor, the original party becomes a guarantor. A guarantee obligation, based on the probability that the third party will pay, is to be recognized and initially measured at fair value. The amount of guarantee obligation increases the loss or reduces the gain recognized on extinguishments.

Gain or loss. According to FASB ASC 470-50-40-2, the difference between the net carrying value and the acquisition price is to be recorded as a gain or loss. If the acquisition price is greater than the carrying value, a loss exists. A gain is generated if the acquisition price is less than the carrying value. These gains or losses are to be recognized in the period in which the retirement took place.

The unamortized premium or discount and issue costs should be amortized to the acquisition date and recorded prior to the determination of the gain or loss. If the extinguishment of debt does not occur on the interest date, the interest payable accruing between the last interest date and the acquisition date must also be recorded.

Except for any gains and losses resulting from satisfying sinking fund requirements within one year of the date of the extinguishment, all gains and losses from extinguishment, if material in amount, receive extraordinary item treatment. Because these gains and losses are not subject to donor restrictions, as a general rule they would be reported as increases or decreases in unrestricted net assets.

Troubled Debt Restructurings

Troubled debt restructurings are defined by the FASB ASC Master Glossary as situations where the creditor, for economic or legal reasons related to the debtor's financial difficulties, grants the debtor a concession that would not otherwise be granted. However, in any of the following four situations, a concession granted by the creditor does not automatically qualify as a restructuring:

1. The fair value of the assets or equity interest accepted by a creditor from a debtor in full satisfaction of its receivable is at least equal to the creditor's recorded investment in the receivable.
2. The fair value of the assets or equity interest transferred by a debtor to a creditor in full settlement of its payable is at least equal to the carrying value of the payable.
3. The creditor reduces the effective interest rate to reflect a decrease in current interest rates or a decrease in the risk, in order to maintain the relationship.
4. The debtor, in exchange for old debt, issues new debt with an interest rate that reflects current market rates.

A troubled debt restructuring can occur one of two ways. The first is a settlement of the debt at less than the carrying amount. The second is a continuation of the debt with a modification of terms (i.e., a reduction in the interest rate, face amount, accrued interest owed, or an extension of the payment date for interest or face amount). Accounting for such restructurings is prescribed by GAAP for both debtors and creditors. The debtor and creditor must individually apply the GAAP requirements to the specific situation since the tests are not necessarily symmetrical and it is possible for one or the other, but not both, to have a troubled debt restructuring. FASB ASC 310-10 specifies the accounting by creditors for troubled debt restructurings involving a modification of terms. GAAP requirements for creditors are generally contained in FASB ASC 310-40-15. GAAP requirements for debtors are generally contained in FASB ASC 470-60-15.

Debtors. If the debt is settled by the exchange of assets, an extraordinary gain is recognized in the period of transfer for the difference between the carrying amount of the debt (defined as the face amount of the debt increased or decreased by applicable accrued interest and applicable unamortized premium, discount, or issue costs) and the consideration given to extinguish the debt. A two-step process is used: (1) a revaluation of the noncash asset to fair value with an associated recognition of an ordinary gain or loss, and (2) a determination of the extraordinary restructuring gain. An exchange of existing debt for new debt with the same creditor and with a higher interest rate (but with the new rate less than the market rate for a company with a similar credit rating) does not result in a recognized gain or loss. In this circumstance, the terms of the exchange are not representative of and are less favorable to the creditor than prevailing terms for new borrowings by companies with similar credit ratings. The result is a concession by the creditor and should be accounted for by debtors as a modification of existing obligation.

If the debt is continued with a modification of terms, it is necessary to compare the total future cash flows of the restructured debt (both principal and stated interest) with the prerestructured carrying value. If the total amount of future cash flows is greater than the carrying value, no adjustment is made to the carrying value of the debt. However, a new, lower effective interest rate must be computed. This rate makes the present value of the total future cash flows equal to the present carrying value of debt and is used to determine interest expense in future periods. The statement specifies that the effective interest method must be used to compute the expense. If the total future cash flows of the restructured debt are less than the present carrying value, the current debt should be reduced to the amount of the future cash flows and an extraordinary gain should be recognized. No interest expense would be recognized in subsequent periods, since only the principal is being repaid.

If the restructuring consists of part settlement and part modification of payments, the part settlement is accounted for first and then the modification of payments.

These rules generally do not apply to debtors in bankruptcy. There is an exception in the case of a restructuring that doesn't result in a general restatement of the debtor's liabilities in bankruptcy proceedings.

The following examples illustrate the accounting for debtors in troubled debt restructurings.

A troubled debt restructuring which involves only a modification of terms is to be accounted for prospectively. The result of this treatment is to effect no change in the carrying value of the liability unless the carrying amount exceeds the total future cash payments specified by the new agreement.

When the total future cash payments may exceed the carrying amount of the liability, no gain or loss is recognized on the books of the debtor. Rather, a new effective interest rate should be determined which is to be the rate that equates the present value of the future cash payments with the carrying amount of the liability. Interest expense and principal reduction are then recognized as the future cash payments are made.

If the total cash payments are less than the carrying amount of the liability, the carrying amount of the liability should be written down to the total future cash payments and the amount of the write-down is to be recognized by the debtor as a gain. This gain is to be aggregated with other gains from restructuring, and the entire amount, if material, should be reported as an extraordinary item. The liability shall be reduced as the payments are made and no interest expense shall be recognized on the liability for any period between the restructuring and the maturity of the liability. An exception exists for contingent liabilities. They generally are not included in the carrying value of the original debt. Thus, for each period that a contingent liability is both probable and reasonably estimable, interest expense shall be recognized. However, to the extent that the contingent payments were included in the total future cash payments, the payment or accrual of these contingencies should be deducted from the restructured liability.

Creditors. Accounting by creditors is similar to that by debtors for troubled debt restructurings involving a receipt of assets by the creditor. However, the loss to the creditor is ordinary, whereas the gain to the debtor is extraordinary.

1. Assets received in full settlement:
   1. All assets that are not fixed assets are recorded at fair value.
   2. Fixed assets are recorded at fair value less cost to sell.
   3. Excess of receivable over the fair value of assets received (less cost to sell if a fixed asset) is an ordinary loss.
   4. Account for assets as if purchased for cash.

FASB ASC 310-10 creditors.

FASB ASC 310-10 applies to all creditors, to all troubled debt restructurings involving a modification of terms, and to all loans except:

1. Groups of similar small balance loans that are collectively evaluated;
2. Loans measured at fair value or lower of cost or fair value;
3. Leases;
4. FASB ASC 320-10 debt securities.

This standard attempts to make consistent the accounting by creditors for impaired loans.

If it is probable that a creditor will not collect all amounts (principal and interest) owed to the degree specified in the loan agreement, a loan is considered impaired. A delay, per se, does not impair the loan if the creditor collects all amounts due (including accrued interest during the delay at the contractual rate).

An impaired loan can be measured on a loan-by-loan basis in any of the following ways:

1. Present value of expected future cash flows using the loan's effective interest rate (the contractual interest rate adjusted for premium or discount and net deferred loan costs or fees at acquisition or origination).
2. Loan's observable market price.
3. Fair value of the collateral if the loan is collateral dependent (repayment expected to be provided by the collateral). If foreclosure is probable, this measurement must be used.

Other measurement considerations include:

1. Costs to sell on a discounted basis if they will reduce cash flows to satisfy the loan.
2. Creation of, or adjustment to, a valuation allowance account with the offset to bad-debt expense if the recorded investment is greater than the impaired loan measurement.
3. If the contractual interest rate varies based on changes in an independent factor, the creditor can choose between:
   1. Calculating the effective interest on the factor as it changes over the loan's life, or
   2. Calculating the effective interest as fixed at the rate in effect at the date of impairment.

      The choice must be consistently applied. Projections of factor changes should not be made.

4. Cash flow estimates should be the creditors' best estimate based on reasonable and supportable assumptions.
5. Significant changes occurring in measurement values require recalculation and adjustment of the valuation allowance. The net carrying amount of the loan should not exceed the recorded investment.

GAAP does not address the recognition, measurement, or display of interest income on unimpaired loans. Creditors can now use existing methods. In most cases, since it doesn't change the measurement of impairment, the amendment ordinarily will only affect how income or expense is classified. The total amount of income would not be affected. However, if the existing policy results in a recorded investment less than fair value, both the classification and the total amount could be affected.

The amended disclosures by creditors for impaired loans should include:

1. Interest income recognition policy (include how cash receipts are recorded).
2. For every period the results of operations are given:
   1. The amount of interest income recognized and the amount that would have accrued if the terms of the original loan agreement had been followed;
   2. The total amount of cash receipts and the amount recorded as a reduction in principal and the amount recorded as interest;
   3. The average recorded investment.
3. The recorded investments classified by whether there is a related allowance for credit losses.

Scope

FASB ASC 420-10 applies to costs associated with an exit activity (that does not involve an organization newly acquired in a business combination) or a disposal activity. It also does not apply to costs associated with the retirement of a long-lived asset covered by FASB ASC 410-20. Examples of these types of costs that are covered are provided in SFAS 146 as follows:

• Termination benefits provided to current employees that are involuntarily terminated under the terms of a benefit arrangement that, in substance, is not an ongoing benefit arrangement or an individual deferred compensation contract (these are referred to as one-time termination benefits).
• Costs to terminate a contract that is not a capital lease.
• Costs to consolidate facilities or relocate employees.

This is not meant to be an all-inclusive list. Exit activities are defined to include a restructuring, which is defined as a program that is planned and controlled by management and materially changes either the scope of a business undertaken by an enterprise or the manner in which that business is conducted. For example, a not-for-profit health and welfare organization may provide separate programs for placing children in day care and for providing temporary shelter to homeless individuals. If management decides to exit all activities related to its homeless program, this would be a restructuring, included in the definition of exit activities.

Liability Recognition

FASB ASC 420-10 requires that a liability for a cost associated with an exit or disposal activity be recognized initially at its fair value in the period in which the liability is incurred. (Certain special rules apply to one-time termination benefits that are incurred over time. These rules are discussed later in this chapter.) FASB ASC 420-10 refers to the fundamental definition of “liability” to define when a liability is incurred: “Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

An obligation becomes a present obligation when a transaction or event occurs that leaves an organization with little or no discretion to avoid the future transfer or use of assets to settle the liability. Since an exit or disposal plan itself does not create a present obligation, specifies that commitment to such a plan, by itself, does not meet the definition for recognition of a liability.

When an obligation does become a present obligation, it should be measured at fair value. Since fair value reflects how much a liability could be settled in a current transaction, when the liability will be settled in future periods, present value calculations should be performed to properly reflect the current fair value of the present obligation. In periods subsequent to initial measurement, changes to the liability are measured using the credit-adjusted risk-free rate of return that was used to measure the liability initially.

One-Time Termination Benefits

As mentioned above, special rules apply for one-time termination benefits. A one-time benefit arrangement exists at the date the plan of termination meets all of the following criteria and has been communicated to employees (referred to as the communication date):

• Management, having the authority to approve the action, commits to a plan of termination.
• The plan identifies the number of employees to be terminated, their job classifications or functions and their locations, and the expected completion date.
• The plan establishes the terms of the benefit arrangement, including the benefits that employees will receive upon termination (including, but not limited to, cash payments) in sufficient detail to enable employees to determine the type and amount of benefits they will receive if they are involuntarily terminated.
• Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

When a liability is recognized for one-time termination benefits depends on whether employees are required to render service until they are terminated in order to receive the termination benefits and, if so, whether employees will be retained to render service beyond a minimum retention period. The minimum retention period cannot exceed any legal notification period or, in the absence of a legal notification period, sixty days.

• If employees are not required to render services until they are terminated in order to receive the termination benefits, a liability for the termination benefits shall be recognized and measured at its fair value at the communication date.
• If employees are required to render services until they are terminated in order to receive the termination benefits and will be retained beyond the minimum retention period, a liability for the termination benefits shall be measured initially at the communication date based on the fair value of the liability as of the termination date. The liability should be recognized ratably over the future service period.

Contract Termination Costs

FASB ASC 420-10 provides specific guidance for termination costs relating to contracts. These costs are segregated into two categories:

• Costs to terminate the contract before its term.

A liability for costs to terminate a contract before the end of its term should be recognized and measured at its fair value when the entity terminates the contract in accordance with the contract terms. For example, a contract may call for the organization to provide written notification to the other party to the contract that the contract is being terminated. When this step is taken and the contract is terminated, a liability is recognized.

• Costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity.

A liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit to the organization should be recognized and measured at fair value when the organization ceases using the right conveyed by the contract, which is referred to as the cease-use date. For operating leases, the fair value of the liability at the cease-use date is determined based on the remaining lease rentals, reduced by estimated sublease rental that could reasonably be obtained for the property, even if the entity does not intend to enter into a sublease.

Statement of Activities Presentation

Costs associated with an exit or disposal activity that does not involve discontinued operations should be included in income from operations in the statement of activities. Costs associated with an exit or disposal activity that involves a discontinued operation should be included in the results of discontinued operations.

If an event or circumstance occurs that discharges or removes an organization's liability for these costs, the liability recorded in prior periods should be reversed through the same line item on the statement of activities used to initially establish the liability.

Disclosures

GAAP requires that the following information be provided in the notes to the financial statements when an exit or disposal activity is initiated and any subsequent period until the activity is completed:

1. A description of the exit or disposal activity, including the facts and circumstances leading to the expected activity and the expected completion date.
2. For each major type of cost associated with the activity.
   1. The total amount expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date;
   2. A reconciliation of the beginning and ending liability balances showing separately the changes during the period attributable to costs incurred and liability with an explanation of the reason(s) therefor.
3. The line item(s) in the statement of activities in which the costs in 2. above are aggregated.
4. For each reportable segment, if applicable, the total amount of costs expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date, net of any adjustment to the liability with an explanation of the reason(s) therefor.
5. If a liability for a cost associated with the activity is not recognized because fair value cannot be reasonably estimated, that fact and the reasons therefor.