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CHAPTER 14: LONG-TERM LIABILITIES


Chapter Outline
I. Basics of Bonds A. Bond Financing 1. A bond is its issuers written promise to pay an amount identified as the par value of the bond and interest at a stated annual rate. a. Most bonds require the issuer to make periodic interest payments. b. Par value of bond, also called the face amount, is paid at a specified future date known as the maturity date. 2. Advantages of bonds a. Bonds do not affect owner control. b. Interest on bonds is tax deductible. c. Bonds can increase return on equity (if return is higher on use of borrowed funds than interest paid; called financial leverage or trading on the equity). 3. Disadvantages of bonds a. Bonds can decrease return on equity (if interest paid is higher than return on use of borrowed funds). b. Bonds require payment of both periodic interest and par value at maturity (required cash outflowdividends on stock not required). B. Bond Trading 1. Bonds can be traded on exchanges (New York Stock Exchange, American Stock Exchange). 2. A bond issue consists of a large number of bonds (denominations of $1,000 or $5,000, etc.) that are sold to many different lenders. 3. Market value (price) is expressed as a percentage of par (face) value. C. Bond Issuing Procedures Governed by state and federal laws. Bond issuers also ensure they do not violate any existing contractual agreements. 1. Bond indenture is the contract between the bond issuer and the bondholders; it identifies the obligations and rights of each party. 2. Issuing corporation sells bonds to an investment firm (the underwriter), which resells bonds to the public. 3. A trustee (usually a bank or trust company) monitors issuer to ensure it complies with the obligations in the indenture.

Notes

Chapter Outline
II. Bond Issuances A. Issuing Bonds at Par Sell bonds for face amount. 1. Issue dateDebit Cash, credit Bonds Payable (face amount). 2. Interest dateDebit Interest Expense, credit Cash (face times bond interest rate times interest period). 3. Maturity dateDebit Bonds Payable, credit Cash (face amount). B. Bond Discount or Premium Sold for amount different than face amount. 1. Contract rate(also called coupon rate, stated rate, or nominal rate) annual interest rate paid by the issuer of bonds (applied to par value). 2. Market rateannual rate borrowers are willing to pay and lenders are willing to accept for a particular bond and its risk level. 3. When contract rate and market rate are equal, bonds sell at par value; when contract rate is above market rate, bonds sell at a premium (above par); when it is below market rate, bonds sell at a discount (below par). C. Issuing Bonds at a Discount Sell bonds for less than par value. 1. Discount on bonds payable is the difference between the par (face) value of a bond and its lower issuance price. 2. Entry: debit Cash (issue price) and Discount on Bonds Payable (amount of discount) and credit Bonds Payable (par value). 3. Discount on Bonds Payable is a contra liability account. 4. Discount is deducted from par value to yield the carrying (or book) value of the bonds payable. 5. Bonds are reported in the long-term liability section of the issuers balance sheet. D. Amortizing a Bond Discount 1. Total bond interest expense is the sum of the interest payments and bond discount (or can be computed by comparing total amount borrowed to total amount repaid over life). 2. Discount must be systematically reduced (amortized) over the life of the bond to report periodic interest expense incurred. 3. Requires crediting Discount on Bonds Payable when bond interest expense is recorded (payment and/or accruals) and increasing Interest Expense by the amortized amount.

Notes

Chapter Outline
4. Amortizing discount updates the book value of the bond (periodically increases book value until, at maturity, book value equals face value). 5. Two methods of amortization: a. Straight-line(simpler) allocates an equal portion of the total discount to bond interest expense in each of the sixmonth interest periods. b. Effective interest methoddiscussed in Appendix 14B E. Issuing Bonds at a Premium Sell bonds for more than par value. 1. Premium on bonds payable is the difference between the par value of a bond and its higher issuance price. 2. Entry: debit Cash (issue price) and credit Premium on Bonds Payable (amount of premium) and Bonds Payable (par value). 3. Premium on Bonds Payable is a liability account. 4. Premium is added to par value to yield the carrying (or book) value of the bonds payable. F. Amortizing a Bond Premium 1. Total bond interest expense incurred is the interest payments less the bond premium. 2. Premiums must be systematically reduced (amortized) over the life of the bond to report periodic interest expense incurred. 3. Requires debiting Premium on Bonds Payable when bond interest expense is recorded (payment and/or accruals) and decreasing Interest Expense by the amortized amount. 4. Amortizing premium updates the book value of the bond (periodically decreases book value until; at maturity, book value equals face value). 5. Two methods of amortization: a. Straight-linesame as for a discount. b. Effective interest methoddiscussed in Appendix 14B

Notes

Chapter Outline
G. Bond Pricing Price (quote) is the present value of bond's future cash flows discounted at the bonds market rate. Present value tables can be used to compute price, which is the combination of the following two values: 1. Present value of the maturity payment (found by using single payment table, the market rate, and number of periods until maturity). 2. Present value of the series of interest payments (found by using annuity table, the market rate, and number of periods until maturity). Bond Retirement A. At Maturity 1. Carrying value will equal par value. 2. Debit Bonds Payable, credit Cash. B. Before Maturity 1. Two common approaches: a. Exercise a call optionpay par value plus a call premium. b. Purchase them on the open market. 2. Difference between the purchase price and the bonds' carrying value is recorded as a gain (or loss) on retirement of bonds. C. By Conversion The carrying value of bonds is transferred to paid-in capital accounts and no gain or loss is recorded. Long-Term Notes PayableIssued to finance operations. Unlike bonds, usually involve a single lender. The note is recorded at its selling price and over the notes life the interest expense allocated to each period is computed by multiplying the market rate (at issuance) by the beginning of the period note balance. A. Installment Notes Obligations requiring a series of periodic payments to the lender. 1. At issue recorded as a debit to assets received and a credit to Notes Payable. 2. Payments include interest expense accruing to the date of the payment plus a portion of the amount borrowed (the principal).

Notes

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Chapter Outline
3. Two possible payment patterns: a. Accrued interest plus equal principal payments i. Cash flows decrease over life of note (each payment reduces the notes principal balance an equal amount, yielding less accrued interest expense for the next period). ii. Debit Notes Payable (principal payment) and Interest Expense (issue rate times the declining carrying value of note) and credit Cash for the total of the two. b. Equal total payments i. Consists of changing amounts of interest and principal. ii. Credit Cash for the amount of the equal payment and debit Interest Expense (issue rate times the declining carrying value of note) and Notes Payable (for difference between the equal payment and the interest expense). B. Mortgage Notes and Bonds Mortgage notes carry a mortgage contract pledging title to specific assets as security for the note. 1. Accounting for mortgage notes and bondssimilar to accounting for unsecured notes and bonds. 2. Mortgage agreements must be disclosed in financial statements. Decision AnalysisDebt Features and the Debt-to-Equity Ratio A. Features of Bonds and Notes 1. Secured bonds have specific assets of the issuer pledged (or mortgaged) as collateral. 2. Unsecured bonds, also called debentures, are backed by the issuers general credit standing. 3. Term bonds are scheduled for maturity at a single specified date. 4. Serial bonds mature at several different dates (repaid over a number of periods). 5. Registered bonds are issued in the names and addresses of their holders. Bond payments are sent directly to these registered holders. 6. Bearer bonds are made payable to whoever holds them; not registered.

Notes

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Chapter Outline
7. Coupon bonds are issued with interest coupons attached to the bond certificate; the coupons are detached as they become due and are presented to a bank for collection. 8. Convertible bonds can be exchanged by for a fixed number of shares of the issuing companys common stock 9. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity. B. Debt-to-Equity Ratio 1. Assess the risk of a companys financing structure. 2. Computed by dividing total liabilities by total equity. 3. Ratio describes contribution of debtholders to equityholders. Present Value of Bonds and Notes Appendix 14A A. Present Value Concepts 1. Cash paid (or received) in the future has less value now than the same amount of cash paid (or received) today. 2. An amount borrowed equals the present value of the future payment. 3. Compounded interest means interest for a second period is based on the total of the amount borrowed plus the interest accrued from the first period. B. Present Value TablesComplete tables found in Appendix B 1. Present values can be computed using a formula or a table. 2. Present Value tables or formula can be used to determine present value of future cash payments of a single amount or an annuity. 3. Present value of $1 table or formula (1/(1+i)n )is used to compute present value of a single payment. (i =interest rate per period, n is the number of periods) 4. Present value of an annuity of $1 table is used to compute present value of a series of equal payments (annuity). C. Applying a Present Value Table 1. Determine the column with the interest rate. 2. Determine the row with the periods hence. 3. The column and row will intersect at the factor number. 4. To convert the single payment or annuity to its PV, multiply this amount by the factor. D. Compounding Periods Shorter than a Year 1. Interest rates are generally stated as annual rates. 2. They can be allocated to shorter periods of time.

Notes

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Chapter Outline
VII. Effective Interest AmortizationAppendix 14B A. Effective Interest Amortization of a Discount Bond 1. Straight-line method yields changes in the bonds carrying value while the bond interest expense remains constant. 2. Effective interest method allocates bond interest expense over the life of the bonds in a way that yields a constant rate of interest equivalent to the market rate of interest on issue date. 3. Bond interest expense incurred for a period equals the carrying value (beginning of period) of the bond multiplied by the market rate. 4. Periodic amortization of bond discount equals bond interest expense incurred less bond interest paid. B. Effective Interest Amortization of a Premium Bond Same as a Discount Bond (above) except for (4) Periodic amortization of bond premium equals bond interest paid less bond interest expense incurred. Issuing Bonds between Interest DatesAppendix 14C A. Procedure used to simplify recordkeeping: 1. Buyers pay the purchase price plus any interest accrued since the prior interest payment date. 2. This accrued interest is repaid to these buyers on the next interest date. 3. The collection of the accrued interest is recorded as a liability until returned. B. Accruing Bond Interest Expense 1. Necessary when bonds interest period does not coincide with issuer's accounting period. 2. Adjusting entry is necessary to record bond interest expense accrued since the most recent interest payment and (requires amortization of the premium or discount for this period). 3. Affects the subsequent interest payment date entry. Leases and PensionsAppendix 14D A. Lease is a contractual agreement between a lessor (asset owner) and a lessee (asset renter or tenant ) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. B. Operating leases are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. 1. Lessee records lease payments as expenses. 2. Lessor records lease payments as revenues.

Notes

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Chapter Outline
C. Capital leases are long-term (or noncancelable) leases in which the lessor transfers substantially all risks and rewards of ownership to the lessor. 1. Lessee records the leased item as its own asset along with the lease liability at the start of the lease term. 2. Lessee depreciates leased asset over period of lease. 3. At each lease payment date, the liability is amortized to record interest expense incurred. 4. Failure to meet one of the four criteria for capital leases will result in off-balance-sheet financing (acquisition of assets with related liabilities not recorded on the balance sheet). D. Pension plan is a contractual agreement between an employer and its employees for the employer to provide benefits (payments) to employees after they have retired. 1. Employer records their payment into pension plan as a debit to Pension Expense and a credit to Cash. 2. Defined benefit plans can be overfunded (plan assets exceed accumulated benefits) resulting in a reported plan asset or underfunded (plan assets are less than accumulated benefits) resulting in plan liabilities.

Notes

Alternate Demonstration Problem Chapter Fourteen ABC Company issued $200,000 face value bonds on January 1, 2009, with semiannual interest payments to be made on June 30 and December 31 at a contract rate of 10%. The bonds were scheduled to mature five years after they were issued. Three years after they were issued, on January 1, 2012, the company repurchased 40% of the outstanding bonds for $79,000. Required: Part A 1. Assume that the bonds were issued when the market rate of interest was 9%. Prepare a schedule showing the bond interest expense and amounts of amortization for the life of the bonds. Prepare the journal entry to record the bond issuance. Prepare journal entries for the first two interest payments. Prepare the journal entry to recognize the partial repurchase of the bonds.

2. 3. 4.

Part B Redo Part A under the assumption that the market rate on the bonds when issued was 16%.

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Solution: Alternate Demonstration Problem Chapter Fourteen Part A 1.


Beginning of Period Carrying Amount Interest Expense to be Recorded Interest to be Paid Premium Unamortized to Bondto be Premium end holders Amortized of Period End-ofPeriod Carrying Amount

Period

0 1 2 3 4 5 6 7 8 9 10

$207,907 207,263 206,590 205,887 205,152 204,384 203,581 202,742 201,865 200,949

$9,356 9,327 9,297 9,265 9,232 9,197 9,161 9,123 9,084 9,051

$10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

$644 673 703 735 768 803 839 877 916 949

$7,907 7,263 6,590 5,887 5,152 4,383 3,581 2,742 1,865 949 0

$207,907 * 207,263 206,590 205,887 205,152 204,384 203,581 202,742 201,865 200,949 200,000

*Present value of $200,000 to be received in 10 periods, discounted at 4.5% per period: $200,000 x .6439 = $128,780 Present value of $10,000 to be received periodically for 10 periods, discounted at 4.5% per period: $10,000 x 7.9127 = 79,127 $207,907

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1/1/09 Cash ...................................................................... Bonds Payable ............................................... Premium on Bonds Payable ......................... 6/30/09 Bond Interest Expense ....................................... Premium on Bonds Payable ............................... Cash ................................................................ 12/31/09 Bond Interest Expense ....................................... Premium on Bonds Payable ............................... Cash ................................................................

207,907 200,000 7,907

3.

9,356 644 10,000

9,327 673 10,000

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4.

1/1/12 Bonds Payable ..................................................... Premium on Bonds Payable ............................... Cash ................................................................ Gain on the Retirement of Bonds ................

80,000 1,432 79,000 2,432

Part B 1.
Beginning of-Period Carrying Amount Interest Interest to Expense be Paid Discount Unamortized to be to Bondto be Discount end Recorded holders Amortized of Period End-ofPeriod Carrying Amount

Period

0 1 2 3 4 5 6 7 8 9 10

$159,741 162,520 165,522 168,764 172,265 176,046 180,130 184,540 189,303 194,447

$12,779 13,002 13,242 13,501 13,781 14,084 14,410 14,763 15,144 15,553

$10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

$2,779 3,002 3,242 3,501 3,781 4,084 4,410 4,763 5,144 5,553

$40,259 37,480 34,478 31,236 27,735 23,954 19,870 15,460 10,697 5,553 0

$159,741 162,520 165,522 168,764 172,265 176,046 180,130 184,540 189,303 194,447 200,000

*Present value of $200,000 to be received in 10 periods, discounted at 8% per period: $200,000 x .4632 = $ 92,640 Present value of $10,000 to be received periodically for 10 periods, discounted at 8% per period: $10,000 x 6.7101 = 67,101 $159,741

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1/1/09 Cash ...................................................................... Discount on Bonds Payable ............................... Bonds Payable ............................................... 6/30/09 Bond Interest Expense ....................................... Discount on Bonds Payable ......................... Cash ................................................................ 12/31/09 Bond Interest Expense ....................................... Discount on Bonds Payable ......................... Cash ................................................................ 1/1/12 Bonds Payable ..................................................... Loss on the Retirement of Bonds ...................... Discount on Bonds Payable ......................... Cash ................................................................

159,741 40,259 200,000

3.

12,779 2,779 10,000

4.

13,002 3,002 10,000

80,000 6,948 7,948 79,000