Explain the accounting for notes and bonds
NOTES AND BONDS
U.S. GAAP and IFRS account for notes and nonconvertible bonds payable similarly. Firms
initially record long-term notes and bonds at their issue price, the present value of the future
contractual cash flows discounted at the market interest rate for the bonds at the time of
issue. The market interest rate at the time of issue is the rate that discounts the contractual
cash flows to the initial issue price. If the market interest rate equals the coupon rate for the
bonds, the firm will issue the bonds for face value. If the market interest rate exceeds the coupon rate, the firm will issue the bonds for less than face value. If the coupon rate exceeds the market interest rate, the firm will issue the bonds for more than face value. Firms must amortize the difference between the issue price and the face value as an adjustment to interest expense over the life of the bonds. Amortization uses the effective interest method, in which interest expense each period equals the market interest rate for the bonds at the time of issue times the carrying value of the debt at the beginning of the period. The difference between interest expense and any cash payment increases (in the case of debt initially issued for less than face value) or decreases (in the case of debt initially issued for more than face value) the carrying value of the debt. Firms that repay debt prior to maturity record a gain or loss for the difference between the purchase price and the carrying value of the debt.
U.S. GAAP and IFRS require firms to disclose the fair value of long-term notes and bonds in notes to the financial statements. Fair value is the amount the firm would pay to settle the debt on the date of the balance sheet, the current market price in the case of items that trade in active markets. For other items, firms measure fair value using techniques and assumptions that market participants would use, for example, the present value of the contractual cash flows discounted at a current market interest rate that reflects all the factors that market participants would consider, including the item's credit risk.
Firms can adopt the fair value option for long-term notes and bonds. If so, the balance sheet carrying amounts for these items are the fair value amounts that they disclose in the notes if they did not adopt the fair value option. The offsetting debit or credit for the remeasurement is to an unrealized loss or gain, which under the fair value option the firm includes in net income.
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