CHAPTER15. Long-Term Liabilities. Acct

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1 CHAPTER15 Long-Term Liabilities Acct

2 15-2 PreviewofCHAPTER15

3 Bond Basics Bonds are a form of interest-bearing notes payable. Three advantages over common stock: 1. Stockholder control is not affected. 2. Tax savings result. 3. Earnings per share may be higher SO 1 Explain why bonds are issued.

4 Bond Basics Effects on earnings per share stocks vs. bonds. Illustration SO 1 Explain why bonds are issued.

5 Bond Basics Question Major disadvantages resulting from the use of bonds are: a. that interest is not tax deductible and the principal must be repaid. b. that the principal is tax deductible and interest must be paid. c. that neither interest nor principal is tax deductible. d. that interest must be paid and principal repaid SO 1 Explain why bonds are issued.

6 Bond Basics Types of Bonds Secured and Unsecured (debenture) bonds. Term and Serial bonds. Registered and Bearer (or coupon) bonds. Convertible and Callable bonds SO 1 Explain why bonds are issued.

7 Bond Basics Issuing Procedures State laws grant corporations the power to issue bonds. Board of directors and stockholders must approve bond issues. Board of directors must stipulate number of bonds to be authorized, total face value, and contractual interest rate. Bond contract known as a bond indenture. Paper certificate, typically a $1,000 face value SO 1 Explain why bonds are issued.

8 Bond Basics Issuing Procedures Represents a promise to pay: sum of money at designated maturity date, plus periodic interest at a contractual (stated) rate on the maturity amount (face value). Interest payments usually made semiannually. Generally issued when the amount of capital needed is too large for one lender to supply SO 1 Explain why bonds are issued.

9 Bond Basics Issuer of Bonds Illustration 15-3 Maturity Date Contractual Interest Rate Face or 15-9 Par Value SO 1 Explain why bonds are issued.

10 Bond Basics Determining the Market Value of Bonds Market value is a function of the three factors that determine present value: 1. dollar amounts to be received, 2. length of time until the amounts are received, and 3. market rate of interest. The features of a bond (callable, convertible, and so on) affect the market rate of the bond SO 1 Explain why bonds are issued.

11 Accounting for Bond Issues Corporation records bond transactions when it issues (sells), retires (buys back) bonds and when bondholders convert bonds into common stock. NOTE: If bondholders sell their bond investments to other investors, the issuing firm receives no further money on the transaction, nor does the issuing corporation journalize the transaction SO 2 Prepare the entries for the issuance of bonds and interest expense.

12 Accounting for Bond Issues Issue at Par, Discount, or Premium? Illustration 15-4 Bond Contractual Interest Rate of 10% SO 2 Prepare the entries for the issuance of bonds and interest expense.

13 Accounting for Bond Issues Question The rate of interest investors demand for loaning funds to a corporation is the: a. contractual interest rate. b. face value rate. c. market interest rate. d. stated interest rate SO 2 Prepare the entries for the issuance of bonds and interest expense.

14 Accounting for Bond Issues Question Karson Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that: a. the contractual interest rate exceeds the market interest rate. b. the market interest rate exceeds the contractual interest rate. c. the contractual interest rate and the market interest rate are the same. d. no relationship exists between the two rates SO 2 Prepare the entries for the issuance of bonds and interest expense.

15 Accounting for Bond Issues Issuing Bonds at Face Value Illustration: On January 1, 2012, Candlestick Corporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is: Jan. 1 Cash 100,000 Bonds payable 100, SO 2 Prepare the entries for the issuance of bonds and interest expense.

16 Issuing Bonds at Face Value Illustration: On January 1, 2012, Candlestick Corporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable semiannually on January 1 and July 1. Prepare the entry to record the payment of interest on July 1, 2012, assume no previous accrual. July 1 Interest expense 5,000 Cash 5, SO 2 Prepare the entries for the issuance of bonds and interest expense.

17 Issuing Bonds at Face Value Illustration: On January 1, 2012, Candlestick Corporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable semiannually on January 1 and July 1. Prepare the entry to record the accrual of interest on December 31, 2012, assume no previous accrual. Dec. 31 Interest expense 5,000 Interest payable 5, SO 2 Prepare the entries for the issuance of bonds and interest expense.

18 Accounting for Bond Issues Issuing Bonds at a Discount Illustration: On January 1, 2012, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $92,639 (92.639% of face value). Interest is payable on July 1 and January 1. The entry to record the issuance is: Jan. 1 Cash 92,639 Discount on bonds payable 7,361 Bond payable 100, SO 2 Prepare the entries for the issuance of bonds and interest expense.

19 Issuing Bonds at a Discount Statement Presentation Illustration 15-5 Carrying value or book value Sale of bonds below face value causes the total cost of borrowing to be more than the bond interest paid. The reason: Borrower is required to pay the bond discount at the maturity date. Thus, the bond discount is considered to be a increase in the cost of borrowing SO 2 Prepare the entries for the issuance of bonds and interest expense.

20 Issuing Bonds at a Discount Total Cost of Borrowing Illustration 15-6 Illustration SO 2 Prepare the entries for the issuance of bonds and interest expense.

21 Issuing Bonds at a Discount Question Discount on Bonds Payable: a. has a credit balance. b. is a contra account. c. is added to bonds payable on the balance sheet. d. increases over the term of the bonds SO 2 Prepare the entries for the issuance of bonds and interest expense.

22 Accounting for Bond Issues Issuing Bonds at a Premium Illustration: On January 1, 2012, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $108,111 ( % of face value). Interest is payable on July 1 and January 1. The entry to record the issuance is: Jan. 1 Cash 108,111 Bonds payable 100,000 Premium on bond payable 8, SO 2 Prepare the entries for the issuance of bonds and interest expense.

23 Issuing Bonds at a Premium Statement Presentation Illustration 15-8 Sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid. The reason: The borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the bond premium is considered to be a reduction in the cost of borrowing SO 2 Prepare the entries for the issuance of bonds and interest expense.

24 Issuing Bonds at a Premium Total Cost of Borrowing Illustration 15-9 Illustration SO 2 Prepare the entries for the issuance of bonds and interest expense.

25 Accounting for Bond Retirements Redeeming Bonds at Maturity Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows: Bond payable 100,000 Cash 100, SO 3 Describe the entries when bonds are redeemed or converted.

26 Accounting for Bond Retirements Redeeming Bonds before Maturity When bonds are retired before maturity, it is necessary to: 1. eliminate carrying value of bonds at redemption date; 2. record cash paid; and 3. recognize gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date SO 3 Describe the entries when bonds are redeemed or converted.

27 Accounting for Bond Retirements Question When bonds are redeemed before maturity, the gain or loss on redemption is the difference between the cash paid and the: a. carrying value of the bonds. b. face value of the bonds. c. original selling price of the bonds. d. maturity value of the bonds SO 3 Describe the entries when bonds are redeemed or converted.

28 Accounting for Bond Retirements Illustration: Assume Candlestick, Inc. has sold its bonds at a premium. At the end of the eighth period, Candlestick retires these bonds at 103 after paying the semiannual interest. The carrying value of the bonds at the redemption date is $101,623. Candlestick makes the following entry to record the redemption at the end of the eighth interest period (January 1, 2016): Bonds payable 100,000 Premium on bonds payable 1,623 Loss on bond redemption 1,377 Cash 103, SO 3 Describe the entries when bonds are redeemed or converted.

29 Accounting for Bond Retirements Converting Bonds into Common Stock Until conversion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option. Upon conversion, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized SO 3 Describe the entries when bonds are redeemed or converted.

30 Accounting for Bond Retirements Illustration: On July 1 Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion: Bonds payable 100,000 Common stock (2,000 x $10) 20,000 Paid-in capital in excess of par value 80, SO 3 Describe the entries when bonds are redeemed or converted.

31 Accounting for Bond Retirements Question When bonds are converted into common stock: a. a gain or loss is recognized. b. the carrying value of the bonds is transferred to paid-in capital accounts. c. the market price of the stock is considered in the entry. d. the market price of the bonds is transferred to paid-in capital SO 3 Describe the entries when bonds are redeemed or converted.

32 Accounting for Other Long-Term Liabilities Long-Term Notes Payable May be secured by a mortgage that pledges title to specific assets as security for a loan. Typically, terms require borrower to make installment payments over the term of the loan. Each payment consists of interest on the unpaid balance of the loan and a reduction of loan principal. Companies initially record mortgage notes payable at face value SO 4 Describe the accounting for long-term notes payable.

33 Accounting for Other Long-Term Liabilities Illustration: Porter Technology Inc. issues a $500,000, 12%, 20- year mortgage note on December 31, The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows. Illustration SO 4 Describe the accounting for long-term notes payable.

34 Accounting for Other Long-Term Liabilities Illustration: Porter Technology Inc. issues a $500,000, 12%, 20- year mortgage note on December 31, The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows. Dec. 31 Cash 500,000 Mortgage payable 500,000 Jun. 30 Interest expense 30,000 Mortgage payable 3,231 Cash 33, SO 4 Describe the accounting for long-term notes payable.

35 Accounting for Other Long-Term Liabilities Question Each payment on a mortgage note payable consists of: a. interest on the original balance of the loan. b. reduction of loan principal only. c. interest on the original balance of the loan and reduction of loan principal. d. interest on the unpaid balance of the loan and reduction of loan principal SO 4 Describe the accounting for long-term notes payable.

36 15-36

37 Accounting for Other Long-Term Liabilities Lease Liabilities A lease is a contractual arrangement between a lessor (owner of the property) and a lessee (renter of the property). Illustration SO 5 Contrast the accounting for operating and capital leases.

38 Accounting for Other Long-Term Liabilities The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do. Operating Lease Capital Lease Journal Entry: Journal Entry: Rent expense xxx Leased equipment xxx Cash xxx Lease liability xxx A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only noncancellable leases may be capitalized) SO 5 Contrast the accounting for operating and capital leases.

39 Accounting for Other Long-Term Liabilities To capitalize a lease, one or more of four criteria must be met: Transfers ownership to the lessee. Contains a bargain purchase option. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property SO 5 Contrast the accounting for operating and capital leases.

40 Accounting for Other Long-Term Liabilities Illustration: Gonzalez Company decides to lease new equipment. The lease period is four years; the economic life of the leased equipment is estimated to be five years. The present value of the lease payments is $190,000, which is equal to the fair market value of the equipment. There is no transfer of ownership during the lease term, nor is there any bargain purchase option. Instructions: (a) (b) What type of lease is this? Explain. Prepare the journal entry to record the lease SO 5 Contrast the accounting for operating and capital leases.

41 Accounting for Other Long-Term Liabilities Illustration: (a) What type of lease is this? Explain. Capitalization Criteria: 1. Transfer of ownership 2. Bargain purchase option 3. Lease term => 75% of economic life of leased property 4. Present value of minimum lease payments => 90% of FMV of property Capital Lease? NO NO Lease term 4 yrs. Economic life 5 yrs. YES 80% YES - PV and FMV are the same SO 5 Contrast the accounting for operating and capital leases.

42 Accounting for Other Long-Term Liabilities Illustration: (b) Prepare the journal entry to record the lease. Leased asset - equipment 190,000 Lease liability 190,000 The portion of the lease liability expected to be paid in the next year is a current liability. The remainder is classified as a long-term liability SO 5 Contrast the accounting for operating and capital leases.

43 Statement Presentation and Analysis Presentation Illustration SO 6 Identify the methods for the presentation and analysis of long-term liabilities.

44 Statement Presentation and Analysis Analysis Two ratios that provide information about debt-paying ability and long-run solvency are: Debt to Total Assets Ratio Times Interest Earned Ratio SO 6 Identify the methods for the presentation and analysis of long-term liabilities.

45 Statement Presentation and Analysis Analysis Illustration: Kellogg had total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations SO 6

46 Statement Presentation and Analysis Analysis Illustration: Kellogg had total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. Times interest earned indicates the company s ability to meet interest payments as they come due SO 6

47 15-47

48 APPENDIX15A Present Value of Face Value Present Value Concepts Related to Bond Pricing Illustration: Assume that you are willing to invest a sum of money that will yield $1,000 at the end of one year, and you can earn 10% on your money. What is the $1,000 worth today? To compute the answer, 1. divide the future amount by 1 plus the interest rate ($1,000/1.10 = $ OR 2. use a Present Value of 1 table. ($1,000 X.90909) = $ (10% per period, one period from now) SO 7 Compute the market price of a bond.

49 Present Value of Face Value To compute the answer, 1. divide the future amount by 1 plus the interest rate ($1,000/1.10 = $ Illustration 15A SO 7 Compute the market price of a bond.

50 Present Value of Face Value To compute the answer, 2. use a Present Value of 1 table. ($1,000 X.90909) = $ (10% per period, one period from now) SO 7 Compute the market price of a bond.

51 Present Value of Face Value The future amount ($1,000), the interest rate (10%), and the number of periods (1) are known Illustration 15A SO 7 Compute the market price of a bond.

52 Present Value of Face Value If you are to receive the single future amount of $1,000 in two years, discounted at 10%, its present value is $ [($1,000 / 1.10) / 1.10]. Illustration 15A SO 7 Compute the market price of a bond.

53 Present Value of Face Value To compute the answer using a Present Value of 1 table. ($1,000 X.82645) = $ (10% per period, two periods from now) SO 7 Compute the market price of a bond.

54 Present Value of Interest Payments (Annuities) In addition to receiving the face value of a bond at maturity, an investor also receives periodic interest payments (annuities) over the life of the bonds. To compute the present value of an annuity, we need to know: 1) interest rate, 2) number of interest periods, and 3) amount of the periodic receipts or payments SO 7 Compute the market price of a bond.

55 Present Value of Interest Payments (Annuities) Assume that you will receive $1,000 cash annually for three years and the interest rate is 10%. Illustration 15A SO 7 Compute the market price of a bond.

56 Present Value of Interest Payments (Annuities) Assume that you will receive $1,000 cash annually for three years and the interest rate is 10%. Illustration 15A SO 7 Compute the market price of a bond.

57 Present Value of Interest Payments (Annuities) Assume that you will receive $1,000 cash annually for three years and the interest rate is 10%. $1,000 annual payment x = $2, SO 7 Compute the market price of a bond.

58 Computing the Present Value of a Bond Selling price of a bond is equal to the sum of: Present value of the face value of the bond discounted at the investor s required rate of return PLUS Present value of the periodic interest payments discounted at the investor s required rate of return SO 7 Compute the market price of a bond.

59 Computing the Present Value of a Bond Assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Illustration 15A SO 7 Compute the market price of a bond.

60 Computing the Present Value of a Bond Assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Illustration 15A SO 7 Compute the market price of a bond.

61 Computing the Present Value of a Bond Assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Illustration 15A SO 7 Compute the market price of a bond.

62 Computing the Present Value of a Bond Assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Illustration 15A SO 7 Compute the market price of a bond.

63 APPENDIX15C Straight-Line Amortization Amortizing Bond Discount Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2012, for $92,639 (discount of $7,361). Interest is payable on July 1 and January 1. Illustration 15C SO 8 Apply the effective-interest method of amortizing bond discount and bond premium.

64 Amortizing Bond Discount Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2012, for $92,639 (discount of $7,361). Interest is payable on July 1 and January 1. The bond discount amortization for each interest period is $736 ($7,361/10). Journal entry on July 1, 2012, to record the interest payment and amortization of discount is as follows: July 1 Interest Expense 5,736 Discount on Bonds Payable 736 Cash 5, SO 8 Apply the effective-interest method of amortizing bond discount and bond premium.

65 Additional Material for Practice on Bonds Straight-Line Amortization of Bond Discount $6,624 4 = $1, Debit Credit Interest Expense (+E, -OE) 7,656 Discount on Bonds Payable (-xl, +L) 1,656 Cash (-A) 6,000 This method results in equal amounts of interest expense each period. This table shows the straight-line amortization of a

66 Ex: (..previous slide) Bonds priced at 93,3760 (%93,3760 of face value) to reflect the market interest rate. Bonds have a face value of USD and stated interest rate of %6 with annual payments. Do the entries for the issue date (1/1/2007), interest payments (4 years), maturity date (12/31/2010) Straight-Line Method of Amortization Cash Discount on B/P Bonds payable /31/2007 Interest Expense Discount on B/P (6624/4 periods=1656) Cash /31/2008 Interest Expense Discount on B/P (6624/4 periods=1656) Cash /31/2009 Interest Expense Discount on B/P (6624/4 periods=1656) Cash /31/2010 Interest Expense Discount on B/P (6624/4 periods=1656) Cash Bonds payable cash

67 Additional Material for Practice on Bonds (use of straight line amortization method) Accounting for Bonds Issued at Maturity Value (exercise) GENERAL JOURNAL DATE DESCRIPTION DEBIT CREDIT Maturity date Bond payable 100,000 Cash 100,000 To record payment of bonds at maturity When the bonds mature, Bonds payable is debited, which will zero out the account. Cash is credited to record payment to the bondholders.

68 Accounting for Bonds Issued at a Discount GENERAL JOURNAL Contra account to Bonds payable DATE DESCRIPTION DEBIT CREDIT Issue date Cash 98,000 Discount on bonds payable 2,000 Bonds payable 100,000 To record issuance of $100,000, 10-year, 8% bonds sold at 98 (98% of the maturiy value) Market conditions may force a company to accept a discount price for its bonds. Suppose a company issues $100,000 of its 8%, 10-year bonds at 98. The company receives $98,000 ($100, ) at issuance and makes this journal entry. The difference of $2,000 is the discount, and has its own account. Discount on bonds payable is a contra account to Bonds payable

69 Carrying Value of Bonds Payable Long-term liabilities Bonds payable $100,000 Less: Discount on bonds payable ( $2,000) $98,000 Carrying value 15-69

70 Accounting for Bonds Issued at a Discount (interest payments) GENERAL JOURNAL DATE DESCRIPTION DEBIT CREDIT Int. pmt date Interest expense 4,100 Discount on bonds payable 100 Cash 4,000 $100,000 x 8% x 6/12 $2,000/10 x 6/12 Amortize Discount on B/P account with straight line amortization method The company borrowed $98,000, but must pay $100,000 when the bonds mature 10 years later. the $2,000 discount is additional interest expense. The discount becomes interest expense through a process called amortization, the gradual reduction of an item over time. We can amortize a bond discount by dividing it into equal amounts for each interest period. This method is called straight-line amortization and it works very much like the straight-line depreciation method. The journal entry above shows this process

71 Accounting for Bonds Issued at a Premium Companion account to Bonds payable GENERAL JOURNAL DATE DESCRIPTION DEBIT CREDIT Issue date Cash 104,000 Premium on bonds payable 4,000 Bonds payable 100,000 To record issuance of $100,000, 10-year, 8% bonds priced at 104 (104% of maturity value) To illustrate a bond premium, let s change the example. Assume the bonds are priced at 104 (104% of maturity value). In that case, the company receives $104,000 cash upon issuance. Bonds payable and the Premium account each carry a credit balance. The Premium is a companion account to Bonds payable

72 Carrying Value of Bonds Payable Long-term liabilities Bonds payable $100,000 Plus: Premium on bonds payable $4,000 $104,000 Carrying value 15-72

73 Accounting for Bonds Issued at a Premium (interest payment) GENERAL JOURNAL $4,000/10 x 6/12 DATE DESCRIPTION DEBIT CREDIT Int. pmt date Interest expense 3,800 Premium on bonds payable 200 Cash 4,000 $100,000 x 8% x 6/12 The company borrowed $104,000, but only has to pay $100,000 when the bonds mature 10 years later. What happens to the $4,000 Premium account? The Premium reduces Interest expense through amortization. This journal entry shows this process-straight line amortization. The Premium is debited (reduced) by $200. This is computed by dividing the $4,000 premium by the number of years of the bond s life, 10, multiplied by 6/12 of a year. The credit to Cash is the same as before - $100,000 x 8% x 6/12. Interest expense is debited for the interest payment minus the premium amortization

74 Carrying Value Bonds payable Premium $100,000 $200 $4,000 $3,800 Carrying value after first interest payment = $103,

75 Adjusting Entries for Bonds Payable If Interest payments do not occur at the year-end for the bond, then interest must be accrued. GENERAL JOURNAL DATE DESCRIPTION DEBIT CREDIT Interest expense 2,050 Discount on bonds payable 50 Interest payable 2000 (100,000 x 8% x 3/12) $2,000/10 x 3/12 The accrual entry should also amortize any bond discount or premium. Suppose a company issued $100,000 of 8%, 10-year bonds at a $2,000 discount on October 1, The interest payments occur on March 31 and September 30 each year. On December 31, the company accrues interest and amortizes bond discount for three months. Interest payable is credited for three months (October, November, and December). Discount on bonds payable must also be amortized for these three months. The next semiannual interest payment occurs on March 31, 2011, - the company makes the journal entry on the next slide

76 Adjusting Entries for Bonds Payable The following interest payment entry will take into account the adjusting entry previously made GENERAL JOURNAL DATE DESCRIPTION DEBIT CREDIT 3 31 Interest payable 2,000 Interest expense 2,050 Discount on bonds payable 50 Cash 4,000 (100,000 x 8% x 6/12) $2,000/10 x 3/12 The next semi-annual interest payment occurs on March 31, Interest payable is debited to zero out the adjusting entry. Cash is credited for the full semi-annual interest payment. The discount is amortized for three months. Interest expense is a plug number the number that makes the entry balance.

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