Chapter 14

Principles of
Financial Accounting
John J Wild
Ken W Shaw
Barbara Chiappetta
Winston Kwok
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Chapter 14 - Long-Term Liabilities
Chapter 14
Long-Term Liabilities
QUESTIONS
1. A bond is a liability of the issuing company. An ordinary share represents an ownership
interest in the company.
2. Notes payable generally involves borrowing from a single creditor, whereas bonds
payable are usually sold to many different lenders (bondholders).
3. Bonds can allow a company’s owners to increase their return on equity without investing
additional amounts. This result occurs as long as the rate of return on the assets
acquired from the borrowed cash is greater than the interest rate paid on the bonds.
Bonds also help the current owners remain in control of the company. There is also a tax
advantage with bonds when issued by corporations.
4. A trustee for bondholders has the responsibility of monitoring the issuer’s actions,
financial performance, and financial condition to ensure that the obligations in the bond
indenture are met.
5. A bond indenture is a legal contract between the issuing company and the bondholders
that identifies the obligations and rights of both parties. It specifies such items as the
par value of the bonds, the contract interest rate, the due dates for interest payments,
and the maturity date(s) of the bonds. It also may name a trustee, describe the bond
issue in detail, and provide for a sinking fund.
6. The contract rate (also known as the coupon rate, stated rate, or nominal rate) is the rate
that is identified in the bond indenture. It is applied to the par value to determine the size
of the cash interest payments. The market rate is the consensus rate that a company is
willing to pay and that investors are willing to accept for a specific bond.
7. In general, the supply of and demand for bonds affect market rates. The market rate for
a particular bond issue is also affected by risks unique to the issuer (e.g., financial
performance and condition) and the length of time until the bonds mature.
8. The price of bonds can be computed by finding the present value of both the par value at
maturity and the periodic cash interest payments discounted at the market rate of
interest.
9. The issue price of a $2,000 bond sold at 98 ¼ is 98.25% of $2,000, or $1,965. The issue
price of a $6,000 bond priced at 101 ½ is 101.5% of $6,000, or $6,090.
10. The debt-to-equity ratio is calculated by dividing total liabilities by total equity. The
higher a company’s debt-to-equity ratio, the higher proportion of a company’s assets
that are provided by creditors. If a company has a high debt-to-equity ratio, the company
may be at risk during poor economic times, because it must still pay off creditors even
though it may not be earning as much as it did in the past.
11. An entrepreneur (owner) must repay the bondholders the principal (par value) according
to the term of the bonds. He or she must also pay interest on the bonds per the amount
14-1
2 Chapter 14 - Long-Term Liabilities
and frequency cited in the bond indenture, and must adhere to any stipulations
(covenants) specified in the bond contract.
12. From Nestlé’s cash flow statement under financing activities, it shows that Nestlé issued
bonds amounting to 1,219 CHF millions.
13. Adidas’ long-term borrowing decreased by 14.8 Euro million (1,569 -1,337) during the
year ended December 31, 2010.
14. Per Puma’s statement of cash flows (financing section), the company made 6.5 Euro
million of non-current bank borrowing for the year ended December 31, 2010.
15. The Statement of Financial Position of GOME indicates that for the year ended December
31, 2010, the company’s debt-to-equity ratio is 0.13, computed as 1,925,217 divided by
14,735,187. In simple terms this means that for each RMB1.00 contributed by equity
holders, RMB0.13 is contributed by debt holders.
14-2
QUICK STUDIES
Quick Study 14-1 (10 minutes)
1. B Debenture 5. G Sinking fund bond
2. D Bond Indenture 6. E Convertible bond
3. F Bearer bond 7. H Secured bond
4. A Registered bond 8. C Serial bond
1. Bond’s cash proceeds: $120,000 x 1.1725 = $140,700
2. Thirty semiannual interest payments of $6,000.......... $180,000

Less premium ($140,700 - $120,000)............................ (20,700)
Total bond interest expense......................................... $159,300
3. Bond interest expense on first payment date:

$140,700 x 4% = $5,628

2011
Jan. 1 Cash....................................................................... 140,700

Bonds Payable ................................................ 120,000
Premium on Bonds Payable .......................... 20,700
To record issuing bonds at a premium.
14-3
Using facts in QS 14-2, the bond’s cash proceeds for the bond selling at
a premium are computed as
Cash Flow Table Value Present Value
$120,000 par (maturity) value ............. 0.3083 $ 36,996
$ 6,000 interest payment ................... 17.2920 103,752
Price of Bond...................................... $140,748*
*
Agrees with $140,700 as given in QS 14-2, except for rounding difference.

2011
July 1 Bonds Payable .................................................. 200,000
Premium on Bonds Payable............................. 8,000
Gain on Retirement of Bonds* ................... 3,000
Cash ............................................................. 205,000
To record retirement of bonds before maturity.
*$3,000 = $208,000 - $205,000

2011
Jan. 1 Bonds Payable.................................................... 1,000,000
Share Capital* ............................................... 250,000
Share Premium-Ordinary................................. 750,000
To record retirement of bonds by share
conversion. *500,000 shares x $0.50

Initial cash proceeds from note
Amount of annual payment = Table B.3 present value for 5 payments
a. 4%: Payment = $170,000 / 4.4518 = $38,187*

b. 8%: Payment = $170,000 / 3.9927 = $42,578*
c. 12%: Payment = $170,000 / 3.6048 = $47,159*
*Rounded to dollars.
14-4

Ratio of debt to equity
Canal Company Sears Company
Total liabilities.......................... $492,000 $ 384,000
Total equity .............................. $656,000 $1,200,000
Debt-to-equity ratio.................. 0.75 0.32
Analysis and interpretation: Canal Company’s debt-to-equity ratio of 0.75

implies a riskier financing structure than Sears Company’s 0.32 debt-to-
equity ratio.
a. The par value of the 4.625% bond issuance is £ 350 million. The
carrying amount is £ 392 million.
b. Given part a, we know that the carrying amount exceeds the par value.
Thus, the bond issuance was sold at a premium. (This also implies that
the contract rate exceeded the market rate.)
14-5
a. There is an inverse relation between market rates and bond prices (to
see this, look at the decreasing discount rate as the yield rate increases
in present value tables of Appendix A). Given that the 4.625%
debentures now trade at a discount (98.0) and assuming that Vodafone’s
credit ratings have not changed, we conclude that market rates for this
type of debt have risen above 4.625% since the bonds were issued. This
is confirmed via its 4.899% market rate from Yahoo!
b. No, the change in market rates since it issued the bonds does not affect
interest expense. Once the bonds are recorded on the balance sheet,
neither the coupon rate nor the yield (market) rate used to compute
interest expense is changed. Bonds (and notes) are recorded at
amortized cost.
c. Because the bonds trade at a discount in the market (98.0), it would be

paying less to retire the bonds than the balance sheet (carrying) value.
Its cash outflow would be £343 million (£350 million × 98.0%). This would
result in a gain on repurchase of bonds of £49 million (£392 million -
$343 million), which would increase current income.
d. Vodafone must repay the par amount of the bonds at maturity. Because
this is the only cash flow that the bondholders will receive, the market
price of the bonds will equal the par amount at that time. For the 4.625%
bonds, that would be £350 million at maturity. (This assumes the interest
payment was already recorded.)
14-6
EXERCISES
Exercise 14-1 (15 minutes)
1. Semiannual cash interest payment = $1,700,000 x 9% x 1/2 = $76,500
2. Journal entries
2011
(a)
Jan. 1 Cash............................................................. 1,700,000
Bonds Payable ...................................... 1,700,000
Sold bonds at par.
(b)
June 30 Bond Interest Expense ............................... 76,500
Cash....................................................... 76,500
Paid semiannual interest on bonds.
(c)
Dec. 31 Bond Interest Expense ............................... 76,500
Cash....................................................... 76,500
Paid semiannual interest on bonds.
3.
2011
(a)
Jan. 1 Cash* ........................................................... 1,666,000
Discount on Bonds Payable ...................... 34,000
Bonds Payable ...................................... 1,700,000
Sold bonds at 98. *($1,700,000 x 0.98)
(b)
Jan. 1 Cash* ........................................................... 1,734,000
Premium on Bonds Payable ................ 34,000
Bonds Payable ...................................... 1,700,000
Sold bonds at 102. *($1,700,000 x 1.02)
14-7
1. Discount = Par value - Issue price = $250,000 - $231,570 = $18,430
2. Total bond interest expense over the life of the bonds

Amount repaid
Six payments of $11,250 .............. $ 67,500
Par value at maturity..................... 250,000
Total repaid ................................... 317,500
Less amount borrowed ................... (231,570)
Total bond interest expense ........... $ 85,930
or
Six payments of $11,250 ................. $ 67,500
Plus discount ................................... 18,430
3. Effective interest amortization table

(A) (B) (C) (D) (E)
Semiannual Cash Interest Bond Interest Discount Unamortized Carrying
Interest Paid Expense Amortization Discount Amount
Period-End [4.5% x $250,000] [6% x Prior (E)] [(B) - (A)] [Prior (D) - (C)] [$250,000 - (D)]
1/01/2011 $18,430 $231,570
6/30/2011 $11,250 $13,894 $ 2,644 15,786 234,214
12/31/2011 11,250 14,053 2,803 12,983 237,017
6/30/2012 11,250 14,221 2,971 10,012 239,988
12/31/2012 11,250 14,399 3,149 6,863 243,137
6/30/2013 11,250 14,588 3,338 3,525 246,475
12/31/2013 11,250 14,775 * 3,525 0 250,000
$67,500 $85,930 $18,430

*Adjusted for rounding.
14-8
1. Premium = Issue price - Par value = $819,700 - $800,000 = $19,700
2. Total bond interest expense over the life of the bonds
Amount repaid
Six payments of $52,000 .............. $ 312,000
Par value at maturity..................... 800,000
Total repaid ................................... 1,112,000
or
Six payments of $52,000 ................. $ 312,000
Less premium .................................. (19,700)
3. Effective interest amortization table

(A) (B) (C) (D) (E)
Semiannual Cash Interest Bond Interest Premium Unamortized Carrying
Interest Paid Expense Amortization Premium Amount
Period-End [6.5% x $800,000] [6% x Prior (E)] [(A) - (B)] [Prior (D) - (C)] [800,000 + (D)]
1/01/2011 $19,700 $819,700
6/30/2011 $ 52,000 $ 49,182 $ 2,818 16,882 816,882
12/31/2011 52,000 49,013 2,987 13,895 813,895
6/30/2012 52,000 48,834 3,166 10,729 810,729
12/31/2012 52,000 48,644 3,356 7,373 807,373
6/30/2013 52,000 48,442 3,558 3,815 803,815
12/31/2013 52,000 48,185* 3,815 0 800,000
$312,000 $292,300 $19,700

14-9

1. Semiannual cash interest payment = $600,000 x 6% x ½ year = $18,000
2. Number of payments = 10 years x 2 per year = 20 semiannual payments
3. The 6% contract rate is less than the 8% market rate; therefore, the
bonds are issued at a discount.
4. Estimation of the market price at the issue date

Cash Flow Table Table Value* Amount Present Value
Par (maturity) value ... B.1 0.4564 $600,000 $273,840
Interest (annuity)........ B.3 13.5903 18,000 244,625
Price of bonds............ $518,465
* Table values are based on a discount rate of 4% (half the annual market rate) and 20
periods (semiannual payments).
5. Cash ......................................................................... 518,465

Discount on Bonds Payable................................... 81,535
Bonds Payable .................................................. 600,000
Sold bonds at a discount on the stated issue date.

1. Semiannual cash interest payment = $75,000 x 10% x ½ year = $3,750
2. Number of payments = 5 years x 2 per year = 10 semiannual payments
3. The 10% contract rate is greater than the 8% market rate; therefore, the
bonds are issued at a premium.
4. Estimation of the market price at the issue date

Par (maturity) value .... B.1 0.6756 $75,000 $50,670
Interest (annuity)......... B.3 8.1109 3,750 30,416
Price of bonds............. $81,086
* Table values are based on a discount rate of 4% (half the annual market rate) and 10
periods (semiannual payments).
5. Cash ......................................................................... 81,086

Premium on Bonds Payable ............................. 6,086
Bonds Payable .................................................. 75,000
Sold bonds at a premium on the stated issue date.
14-10
1. Amount of each payment = Initial note balance / Table B.3 value
= $25,000 / 3.3872 = $7,381
2. Amortization table for the loan
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
Period Beginning Interest Notes Ending
Ending Balance Expense + Payable = Cash Balance
Date [Prior (E)] [7% x (A)] [(D) - (B)] [computed] [(A) - (C)]
2011 ...... $25,000 $1,750 $ 5,631 $ 7,381 $19,369
2012 ...... 19,369 1,356 6,025 7,381 13,344
2013 ...... 13,344 934 6,447 7,381 6,897
2014 ...... 6,897 484* 6,897 7,381 0
$4,524 $25,000 $29,524
14-11
2011
Jan. 1 Cash....................................................................... 25,000
Notes Payable ................................................. 25,000
Borrowed $25,000 by signing a 7%
installment note.
2011
Dec. 31 Interest Expense ................................................... 1,750
Notes Payable ....................................................... 5,631
Cash................................................................. 7,381
To record first installment payment.
2012
Notes Payable ....................................................... 6,025
Cash................................................................. 7,381
To record second installment payment.
2013
Dec. 31 Interest Expense ................................................... 934
Notes Payable ....................................................... 6,447
Cash................................................................. 7,381
To record third installment payment.
2014
Dec. 31 Interest Expense ................................................... 484
Notes Payable ....................................................... 6,897
Cash................................................................. 7,381
To record fourth installment payment.
14-12
1a. Current debt-to-equity ratio = $220,000 / $400,000* = 0.55

*Total equity = $620,000 - $220,000 = $400,000
1b. Potential debt-to-equity ratio = $720,000* / $400,000 = 1.80

*Total liabilities = $220,000 + $500,000 = $720,000
2. Ramirez’s risk will increase because it will have more debt. That debt
(plus interest) must be repaid even if the project does not work out as
planned and provide a sufficient profit. However, if the project does
provide adequate returns, Ramirez may be better off in the long run by
borrowing the funds.
1. Cash ............................................................................ 6,361

Premium on Loans and Borrowings ................... 361
Loans and Borrowings ........................................ 6,000
Issued liabilities at premium.
2. Loans and Borrowings .............................................. 2,400

Premium on Loans and Borrowings......................... 32
Loss on Loans and Borrowings Retirement ............ 100
Cash ...................................................................... 2,532
Retirement of loans and borrowings pre-maturity.
3. Heineken’s Loans and Borrowings carried a premium of € 84 as of

December 31, 2008. This is computed as its carrying value of € 9,084
less its par value of € 9,000.
4. The contract rate was higher than the market rate at issuance. This is
implied from the higher carrying value of its loans and borrowings
relative to the lower par value.
(Recall: Contract rate > Market rate Premium)
14-13
PROBLEM SET A
Problem 14-1A (50 minutes)
Part 1
a.
Par value .................. B.1 0.4564 $20,000 $ 9,128
Interest (annuity) ..... B.3 13.5903 1,000 13,590
Price of bonds ......... $22,718
Bond premium......... $ 2,718
* Table values are based on a discount rate of 4% (half the annual market rate)
and 20 periods (semiannual payments).
b.
2011
Jan. 1 Cash............................................................. 22,718
Bonds Payable ...................................... 20,000
Sold bonds on stated issue date.
Part 2
a.
Par value .................. B.1 0.3769 $20,000 $ 7,538
Price of bonds ......... $20,000
* Table values are based on a discount rate of 5% (half the annual market rate) and
20 periods (semiannual payments). (Note: When the contract rate and market rate
are the same, the bonds sell at par and there is no discount or premium.)
b.
2011
Jan. 1 Cash............................................................. 20,000
Bonds Payable ...................................... 20,000
14-14
Problem 14-1A (Concluded)
Part 3
a.

Par value .................... B.1 0.3118 $20,000 $ 6,236
Interest (annuity) ....... B.3 11.4699 1,000 11,470
Price of bonds.......... $17,706
Bond discount ......... $ 2,294
b.
2011
Jan. 1 Cash............................................................. 17,706
Bonds Payable ...................................... 20,000
14-15

Part 1
Ten payments of $16,250 ............... $ 162,500
Par value at maturity ....................... 500,000
Total repaid ...................................... 662,500
or:
Ten payments of $16,250 ................ $ 162,500
Less premium .................................. (10,666)
Part 2
(A) (B) (C) (D) (E)
Period-End [3.25% x $500,000] [3% x Prior (E)] [(A) - (B)] [Prior (D) - (C)] [$500,000 + (D)]
1/01/2011 $10,666 $510,666

6/30/2011 $ 16,250 $ 15,320 $ 930 9,736 509,736
12/31/2011 16,250 15,292 958 8,778 508,778
6/30/2012 16,250 15,263 987 7,791 507,791
12/31/2012 16,250 15,234 1,016 6,775 506,775
6/30/2013 16,250 15,203 1,047 5,728 505,728
12/31/2013 16,250 15,172 1,078 4,650 504,650
6/30/2014 16,250 15,140 1,110 3,540 503,540
12/31/2014 16,250 15,106 1,144 2,396 502,396
6/30/2015 16,250 15,072 1,178 1,218 501,218

12/31/2015 16,250 15,032* 1,218 0 500,000
$162,500 $151,834 $10,666
14-16

Part 3
2011
June 30 Bond Interest Expense .............................. 15,320
Premium on Bonds Payable ..................... 930
Cash...................................................... 16,250
To record six months’ interest and
premium amortization.
2011
Dec. 31 Bond Interest Expense .............................. 15,292
Interest Payable ................................... 16,250
Part 4
As of December 31, 2013
Par value .................. B.1 0.8885 $500,000 $444,250
Price of bonds ......... $504,653
* Table values are based on a discount rate of 3% (half the annual original market
rate) and 4 periods (semiannual payments).
Comparison to Part 2 Table

Except for a small rounding difference, this present value ($504,653) equals
the carrying value of the bonds in column (E) of the amortization table
($504,650). This shows a general rule: The bond balance at any point in
time equals the present value of the remaining cash flows using the market
rate at the time of issuance.
14-17

Part 1
2011
Jan. 1 Cash............................................................ 584,361
Discount on Bonds Payable ..................... 65,639
Bonds Payable ..................................... 650,000
Part 2
Eight payments of $16,250* ............... $ 130,000
Par value at maturity .......................... 650,000
Total repaid ......................................... 780,000
Less amount borrowed ...................... (584,361)
Total bond interest expense .............. $ 195,639
or:
Eight payments of $16,250* ............... $ 130,000
Plus discount ..................................... 65,639
Total bond interest expense ............. $ 195,639
*
Semiannual interest payment, computed as $650,000 x 5% x ½ year.
Part 3
(A) (B) (C) (D) (E)

Period-End [2.5% x $650,000] [4% x Prior (E)] [(B) - (A)] [Prior (D) - (C)] [$650,000 - (D)]
1/01/2011 $65,639 $584,361
6/30/2011 $16,250 $23,374 $7,124 58,515 591,485
12/31/2011 16,250 23,659 7,409 51,106 598,894
6/30/2012 16,250 23,956 7,706 43,400 606,600
12/31/2012 16,250 24,264 8,014 35,386 614,614
14-18
Part 4
2011
Discount on Bonds Payable ............... 7,124
Cash...................................................... 16,250
discount amortization.
2011
Discount on Bonds Payable ............... 7,409
Cash...................................................... 16,250
14-19

Part 1
2011
Jan. 1 Cash............................................................ 92,283
Premium on Bonds Payable ............... 2,283
Bonds Payable ..................................... 90,000
Part 2
Six payments of $4,950 .................. $ 29,700
Total repaid ...................................... 119,700
or:
Six payments of $4,950 ................... $ 29,700
Less premium .................................. (2,283)
Part 3
(A) (B) (C) (D) (E)

1/01/2011 $2,283 $92,283
6/30/2011 $4,950 $4,614 $336 1,947 91,947
12/31/2011 4,950 4,597 353 1,594 91,594
6/30/2012 4,950 4,580 370 1,224 91,224
12/31/2012 4,950 4,561 389 835 90,835
14-20

Part 4
2011
Cash...................................................... 4,950
2011
Cash...................................................... 4,950
Part 5
2013
Jan. 1 Bonds Payable .......................................... 90,000
Cash* .................................................... 88,200
Gain on Retirement of Bonds ............. 2,635
To record the retirement of bonds.
*($90,000 x 98%)
Part 6
If the market rate on the issue date had been 12% instead of 10%, the bonds
would have sold at a discount because the contract rate of 11% would have been
lower than the market rate.
This change would affect the balance sheet because the bond liability would be
smaller (par value minus a discount instead of par value plus a premium). As the
years passed, the bond liability would increase with amortization of the discount
instead of decreasing with amortization of the premium.
The income statement would show larger amounts of bond interest expense over
the life of the bonds issued at a discount than it would show if the bonds had
been issued at a premium.
The statement of cash flows would show a smaller amount of cash received from
borrowing. However, the cash flow statements presented over the life of the
bonds (after issuance) would report the same total amount of cash paid for
interest. This amount is fixed as it is the product of the contract rate and the par
value of the bonds and is unaffected by the change in the market rate.
14-21

Part 1 Amount of Payment
Note balance .............................................. $400,000
Number of periods..................................... 5
Interest rate ................................................ 8%
Value from Table B.3 ................................. 3.9927
Payment ($400,000 / 3.9927)...................... $100,183
Part 2
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
10/31/2012 ..... $400,000 $ 32,000 $ 68,183 $100,183 $331,817
10/31/2013 ..... 331,817 26,545 73,638 100,183 258,179
10/31/2014 ..... 258,179 20,654 79,529 100,183 178,650
10/31/2015 ..... 178,650 14,292 85,891 100,183 92,759
10/31/2016 ..... 92,759 7,424* 92,759 100,183 0

$100,915 $400,000 $500,915
* Adjusted for rounding
Part 3
2011
Interest Payable .............................................. 5,333
Accrued interest on the installment
note payable ($32,000 x 2/12).
2012
Oct. 31 Interest Expense ................................................... 26,667
Interest Payable .................................................... 5,333
Notes Payable ....................................................... 68,183
Cash................................................................. 100,183
Record first payment on installment note
(interest expense = $32,000 - $5,333).
14-22
Part 1
Kumar Company debt-to-equity = $904,500 / $1,350,000 = 0.67
Asher Company debt-to-equity = $598,500 / $525,000 = 1.14
Part 2
Asher’s debt-to-equity ratio is higher than Kumar's. This implies that Asher
is more risky. However, before deciding if either company’s debt-to-equity
ratio is too high (or too low), it is important to evaluate the ability of each
company to meet its obligations from operating cash flows.
14-23
PROBLEM SET B
Problem 14-1B (50 minutes)
Part 1
a.
Par value ................. B.1 0.6139 $45,000 $27,626
Interest (annuity) .... B.3 7.7217 2,700 20,849
Price of bonds ........ $48,475
Bond Premium........ $ 3,475
b.
2011
Jan. 1 Cash............................................................. 48,475
Bonds Payable ...................................... 45,000
Part 2
a.
Par value ................. B.1 0.5584 $45,000 $25,128
Price of bonds ........ $45,000**
* Table values are based on a discount rate of 6% (half the annual market rate) and
10 periods (semiannual payments). (Note: When the contract rate and market
rate are the same, the bonds sell at par and there is no discount or premium.)
**Adjusted for rounding.
b.
2011
Jan. 1 Cash............................................................. 45,000
Bonds Payable ...................................... 45,000
14-24
Problem 14-1B (Concluded)

Part 3
a.
Par value ................. B.1 0.5083 $45,000 $22,874
Price of bonds ........ $41,838
Bond discount ........ $ 3,162
b.
2011
Jan. 1 Cash............................................................. 41,838
Bonds Payable ...................................... 45,000
14-25

Part 1
Ten payments of $7,200 ................. $ 72,000
Total repaid ...................................... 232,000
or:
Ten payments of $7,200 ................. $ 72,000
Less premium .................................. (6,494)
Part 2
(A) (B) (C) (D) (E)
1/01/2011 $6,494 $166,494
6/30/2011 $ 7,200 $ 6,660 $ 540 5,954 165,954
12/31/2011 7,200 6,638 562 5,392 165,392
6/30/2012 7,200 6,616 584 4,808 164,808
12/31/2012 7,200 6,592 608 4,200 164,200
6/30/2013 7,200 6,568 632 3,568 163,568
12/31/2013 7,200 6,543 657 2,911 162,911
6/30/2014 7,200 6,516 684 2,227 162,227
12/31/2014 7,200 6,489 711 1,516 161,516
6/30/2015 7,200 6,461 739 777 160,777
12/31/2015 7,200 6,423* 777 0 160,000

$72,000 $65,506 $6,494
14-26

Part 3
2011
Cash...................................................... 7,200
2011
Interest Payable ................................... 7,200
Part 4
As of December 31, 2013
Par value ................. B.1 0.8548 $160,000 $136,768
Price of bonds ........ $162,903
* Table values are based on a discount rate of 4% (half the annual original market
rate) and 4 periods (semiannual payments).
Comparison to Part 2 Table

Except for a small rounding difference, this present value ($162,903) equals
the carrying value of the bonds in column (E) of the amortization table
($162,911). This reveals a general rule: The bond balance at any point in
time equals the present value of the remaining cash flows using the market
rate at the time of issuance.
14-27

Part 1
2011
Jan. 1 Cash............................................................ 99,247
Discount on Bonds Payable ..................... 20,753
Bonds Payable ..................................... 120,000
Part 2
Thirty payments of $3,600* ............. $108,000
Total repaid ...................................... 228,000
Total bond interest expense ........... $128,753
or:
Thirty payments of $3,600* ............. $108,000
Plus discount ................................... 20,753
Total bond interest expense ........... $128,753
*
Semiannual interest payment, computed as $120,000 x 6% x ½ year.
Part 3
(A) (B) (C) (D) (E)

Period-End [3% x $120,000] [4% x Prior (E)] [(B) - (A)] [Prior (D) - (C)] [$120,000 - (D)]
1/01/2011 $20,753 $ 99,247
6/30/2011 $3,600 $3,970 $370 20,383 99,617
12/31/2011 3,600 3,985 385 19,998 100,002
6/30/2012 3,600 4,000 400 19,598 100,402
12/31/2012 3,600 4,016 416 19,182 100,818
14-28
Part 4
2011
Discount on Bonds Payable ............... 370
Cash...................................................... 3,600
2011
Discount on Bonds Payable ............... 385
Cash...................................................... 3,600
14-29

Part 1
2011
Jan. 1 Cash............................................................ 987,217
Premium on Bonds Payable ............... 87,217
Bonds Payable ..................................... 900,000
Part 2
Eight payments of $58,500 ............. $ 468,000
Total repaid ...................................... 1,368,000
or:
Eight payments of $58,500 ............. $ 468,000
Less premium .................................. (87,217)
Part 3
(A) (B) (C) (D) (E)

1/01/2011 $87,217 $987,217
6/30/2011 $58,500 $49,361 $ 9,139 78,078 978,078
12/31/2011 58,500 48,904 9,596 68,482 968,482
6/30/2012 58,500 48,424 10,076 58,406 958,406
12/31/2012 58,500 47,920 10,580 47,826 947,826
14-30

Part 4
2011
Premium on Bonds Payable ..................... 9,139
Cash...................................................... 58,500
2011
Cash...................................................... 58,500
Part 5
2013
Jan. 1 Bonds Payable .......................................... 900,000
Loss on Retirement of Bonds................... 6,174
Cash* .................................................... 954,000
To record the retirement of bonds.
*($900,000 x 106%)
Part 6
If the market rate on the issue date had been 14% instead of 10%, the bonds
would have sold at a discount because the contract rate of 13% would have been
lower than the market rate.
This change would affect the balance sheet because the bond liability would be
smaller (par value minus a discount instead of par value plus a premium). As the
years passed, the bond liability would increase with amortization of the discount
instead of decreasing with amortization of the premium.
The income statement would show larger amounts of bond interest expense over
the life of the bonds issued at a discount than it would show if the bonds had
been issued at a premium.
The statement of cash flows would show a smaller amount of cash received from
borrowing. However, the cash flow statements presented over the life of the
bonds (after issuance) would report the same total amount of cash paid for
interest. This amount is fixed as it is the product of the contract rate and the par
value of the bonds and is unaffected by the change in the market rate.
14-31

Part 1 Amount of Payment
Note balance .............................................. $300,000
Number of periods..................................... 3
Interest rate ................................................ 10%
Value from Table B.3 ................................. 2.4869
Payment ($300,000 / 2.4869)...................... $120,632
Part 2
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
9/30/2012 ....... $300,000 $30,000 $ 90,632 $120,632 $209,368
9/30/2013 ....... 209,368 20,937 99,695 120,632 109,673
9/30/2014 ....... 109,673 10,959* 109,673 120,632 0
$61,896 $300,000 $361,896

Part 3
2011
Interest Payable .............................................. 7,500
Accrued interest on the installment
note payable ($30,000 x 3/12).
2012
Sept. 30 Interest Expense ................................................... 22,500
Interest Payable .................................................... 7,500
Notes Payable ....................................................... 90,632
Cash................................................................. 120,632
Record first payment on installment note
(interest expense = $30,000 - $7,500).
14-32
Part 1
West Elm Company

Debt-to-equity ratio = $178,596 / $217,800 = 0.82
East Park Company
Debt-to-equity ratio = $1,237,500 / $412,500 = 3.00
Part 2
East Park’s debt-to-equity ratio is much higher than that for West Elm. This
implies that East Park has a more risky financing structure. Before
concluding that either company’s debt-to-equity ratio is too high (or too
low), it is important to evaluate the ability of each company to meet its
obligations from operating cash flows and to assess the return on those
borrowed funds.
14-33
SERIAL PROBLEM — SP 14
Serial Problem — SP 14, Business Solutions (75 minutes)
Part 1
Total equity = $119,393

Thus, total liabilities can be no more than its total equity x 0.8, or
$119,393 x 0.8 = $95,514
This implies that:

Max. total liabilities – Present liability balance = Max. that can be borrowed
$95,514 – $875 = $94,639
Part 2
Assume the secured loan is taken, then the percent of assets financed by:
a. Debt
($875 + $94,639) / ($120,268 + $94,639) = 44.4%
b. Equity
$119,393 / ($120,268 + $94,639) = 55.6%
Part 3
Santana Rey should understand the risks she is taking by borrowing funds
from the bank. She currently has no interest-bearing debt, but the loan will
require her to pay interest. The interest is a fixed cost that must be paid,
no matter what her profits are. She must also consider what she will do
with the borrowed funds. She needs to make sure she can earn a
reasonable return on the assets acquired with the borrowed funds to make
the debt worthwhile.
In addition, and probably more important, Santana Rey should understand

the terms of the loan and have the ability to pay the loan back when it is
due.
14-34

Chapter 14

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Chapter 14

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Principles of

Proprietary and Confidential

Singapore Boston Burr Ridge, IL Dubuque, IA Madison, WI New York

Quick Study 14-2 (10 minutes)

1. Bond’s cash proceeds: $120,000 x 1.1725 = $140,700

2. Thirty semiannual interest payments of $6,000.......... $180,000

3. Bond interest expense on first payment date:

Quick Study 14-3 (10 minutes)

Jan. 1 Cash....................................................................... 140,700

Quick Study 14-4 (10 minutes)

Quick Study 14-5 (10 minutes)

Quick Study 14-6 (10 minutes)

Quick Study 14-7 (10 minutes)

a. 4%: Payment = $170,000 / 4.4518 = $38,187*

Quick Study 14-8 (10 minutes)

Analysis and interpretation: Canal Company’s debt-to-equity ratio of 0.75

Quick Study 14-9 (10 minutes)

Quick Study 14-10 (10 minutes)

c. Because the bonds trade at a discount in the market (98.0), it would be

1. Semiannual cash interest payment = $1,700,000 x 9% x 1/2 = $76,500

Exercise 14-2 (30 minutes)

1. Discount = Par value - Issue price = $250,000 - $231,570 = $18,430

2. Total bond interest expense over the life of the bonds

3. Effective interest amortization table

1/01/2011 $18,430 $231,570

6/30/2011 $11,250 $13,894 $ 2,644 15,786 234,214

12/31/2011 11,250 14,053 2,803 12,983 237,017

6/30/2012 11,250 14,221 2,971 10,012 239,988

12/31/2012 11,250 14,399 3,149 6,863 243,137

6/30/2013 11,250 14,588 3,338 3,525 246,475

12/31/2013 11,250 14,775 * 3,525 0 250,000

$67,500 $85,930 $18,430

Exercise 14-3 (30 minutes)

1. Premium = Issue price - Par value = $819,700 - $800,000 = $19,700

2. Total bond interest expense over the life of the bonds

3. Effective interest amortization table

1/01/2011 $19,700 $819,700

6/30/2011 $ 52,000 $ 49,182 $ 2,818 16,882 816,882

12/31/2011 52,000 49,013 2,987 13,895 813,895

6/30/2012 52,000 48,834 3,166 10,729 810,729

12/31/2012 52,000 48,644 3,356 7,373 807,373

6/30/2013 52,000 48,442 3,558 3,815 803,815

12/31/2013 52,000 48,185* 3,815 0 800,000

$312,000 $292,300 $19,700

Exercise 14-4 (25 minutes)

2. Number of payments = 10 years x 2 per year = 20 semiannual payments

4. Estimation of the market price at the issue date

5. Cash ......................................................................... 518,465

Exercise 14-5 (25 minutes)

2. Number of payments = 5 years x 2 per year = 10 semiannual payments

4. Estimation of the market price at the issue date

5. Cash ......................................................................... 81,086

Exercise 14-6 (20 minutes)

1. Amount of each payment = Initial note balance / Table B.3 value

= $25,000 / 3.3872 = $7,381

2. Amortization table for the loan

2011 ...... $25,000 $1,750 $ 5,631 $ 7,381 $19,369

2012 ...... 19,369 1,356 6,025 7,381 13,344

2013 ...... 13,344 934 6,447 7,381 6,897

2014 ...... 6,897 484* 6,897 7,381 0

$4,524 $25,000 $29,524

*Adjusted for rounding.

Exercise 14-7 (20 minutes)

Exercise 14-8 (15 minutes)