15-1. 15-2 CHAPTER15 Long-Term Liabilities 15-3 PreviewofCHAPTER15.

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15-2

CHAPTER15Long-Term

Liabilities

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PreviewofCHAPTER15

15-4

Bonds are a form of interest-bearing notes payable.

Three advantages over common stock:

SO 1 Explain why bonds are issued.

1. Stockholder control is not affected.

2. Tax savings result.

3. Earnings per share may be higher.

Bond Basics

15-5

Effects on earnings per share—stocks vs. bonds.


Illustration 15-2

Bond Basics

15-6

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.

Question


Bond Basics

15-7

Secured and Unsecured (debenture) bonds.

Term and Serial bonds.

Registered and Bearer (or coupon) bonds.

Convertible and Callable bonds.


Bond Basics

Types of Bonds

15-8

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.


Bond Basics

Issuing Procedures

15-9

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.


Bond Basics

Issuing Procedures

15-10 SO 1 Explain why bonds are issued.

MaturityDate

MaturityDate

Illustration 15-3

Contractual Interest

Rate

Contractual Interest

Rate

Face or Par ValueFace or

Par Value

Bond BasicsIssuer of

BondsIssuer of

Bonds

15-11

Determining the Market Value of Bonds


The features of a bond (callable, convertible, and so on) affect the market rate of the bond.

Bond Basics

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.

15-12

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.

Accounting for Bond Issues

SO 2 Prepare the entries for the issuance of bonds and interest expense.

15-13

Issue at Par, Discount, or Premium?



Illustration 15-4

Bond

Contractual

Interest Rate

of 10%

15-14 SO 2 Prepare the entries for the issuance of bonds and interest expense.

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.


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.

Question


15-16

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 100,000

Issuing Bonds at Face Value


15-17



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 5,000


15-18



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 5,000



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 100,000


Issuing Bonds at a Discount

15-20

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.

Statement Presentation


Illustration 15-5


Carrying value or book value


Total Cost of Borrowing

Illustration 15-6

Illustration 15-7


15-22

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.



Question


Jan. 1 Cash 108,111


Premium on bond payable 8,111

Illustration: On January 1, 2012, Candlestick, Inc. sells

$100,000, five-year, 10% bonds for $108,111 (108.111% of

face value). Interest is payable on July 1 and January 1. The

entry to record the issuance is:


Issuing Bonds at a Premium

15-24

Statement Presentation


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.

Illustration 15-8



Total Cost of Borrowing

Illustration 15-9

Illustration 15-10


15-26 SO 3 Describe the entries when bonds are redeemed or converted.

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 100,000

Accounting for Bond Retirements

Redeeming Bonds at Maturity

15-27

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.


Redeeming Bonds before Maturity

15-28 SO 3 Describe the entries when bonds are redeemed or converted.

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.


Question

15-29

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 103,000



15-30

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.



Converting Bonds into Common Stock

15-31

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:


Common stock (2,000 x $10) 20,000

Paid-in capital in excess of par value 80,000



15-32

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.

Question



15-33

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.

Accounting for Other Long-Term Liabilities

Long-Term Notes Payable

15-34

Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-

year mortgage note on December 31, 2012. 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 15-11


15-35 SO 4 Describe the accounting for long-term notes payable.

Dec. 31 Cash 500,000

Mortgage payable 500,000

Jun. 30 Interest expense 30,000

Mortgage payable 3,231

Cash 33,231


Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-

year mortgage note on December 31, 2012. 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.

15-36

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.



Question

15-37

15-38

A lease is a contractual arrangement between a lessor (owner

of the property) and a lessee (renter of the property).

SO 5 Contrast the accounting for operating and capital leases.

Illustration 15-12


Lease Liabilities

15-39

Operating LeaseOperating Lease Capital LeaseCapital Lease

Journal Entry:

Rent expense xxx

Cash xxx

Journal Entry:

Leased equipment xxx

Lease liability xxx

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.

A lease that transfers substantially all of the benefits and

risks of property ownership should be capitalized (only

noncancellable leases may be capitalized).



15-40

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.



15-41

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) What type of lease is this? Explain.

(b) Prepare the journal entry to record the lease.



15-42

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

NONO

NONO

Lease term

4 yrs.Economic life

5 yrs.

YES

80%

YES - PV and FMV are the same.

Capital Lease?



15-43

Illustration: (b) Prepare the journal entry to record the lease.


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.

Leased asset - equipment 190,000

Lease liability 190,000


15-44

The lessee must record a lease as an asset if the lease:

a. transfers ownership of the property to the lessor.

b. contains any purchase option.

c. term is 75% or more of the useful life of the leased

property.

d. payments equal or exceed 90% of the fair market

value of the leased property.



Question

15-45SO 6 Identify the methods for the presentation

and analysis of long-term liabilities.

Illustration 15-13

Statement Presentation and Analysis

Presentation

15-46

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.


Analysis

15-47

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


Analysis

15-48

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


Analysis

15-49

15-50

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 = $909.09 OR

2. use a Present Value of 1 table. ($1,000 X .90909) = $909.09

(10% per period, one period from now).

SO 7 Compute the market price of a bond.

APPENDIX15APresent Value

Concepts Related to Bond Pricing

Present Value of Face Value

15-51


1. divide the future amount by 1 plus the interest rate

($1,000/1.10 = $909.09.

Illustration 15A-1



15-52 SO 7 Compute the market price of a bond.



2. use a Present Value of 1 table. ($1,000 X .90909) =

$909.09 (10% per period, one period from now).

15-53

The future amount ($1,000), the interest rate (10%), and the

number of periods (1) are known


Illustration 15A-2


15-54

If you are to receive the single future amount of $1,000 in

two years, discounted at 10%, its present value is $826.45

[($1,000 1.10) 1.10].


Illustration 15A-3


15-55

To compute the answer using a Present Value of 1 table.

($1,000 X .82645) = $826.45 (10% per period, two periods

from now).



15-56

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.


Present Value of Interest Payments (Annuities)

15-57

Assume that you will receive $1,000 cash annually for three years and the interest rate is 10%.


Illustration 15A-5



Illustration 15A-6




$1,000 annual payment x 2.48685 = $2,486.85



15-60

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


Computing the Present Value of a Bond

15-61

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-8



15-62

Illustration 15A-9





and July 1.

15-63

Illustration 15A-10





and July 1.

15-64

Illustration 15A-11





and July 1.

15-65

Under the effective-interest method, the amortization of

bond discount or bond premium results in period interest

expense equal to a constant percentage of the carrying

value of the bonds.

Required steps:

SO 8 Apply the effective-interest method of amortizing bond discount and bond premium.

1. Compute the bond interest expense.

2. Compute the bond interest paid or accrued.

3. Compute the amortization amount.

APPENDIX15BEffective-Interest Method of Bond Amortization

15-66

Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year

bonds on January 1, 2010, for $92,639, with interest payable each

July 1 and January 1. This results in a discount of $7,361.

Illustration 15B-2


Effective-Interest Method of Bond Amortization

Amortizing Bond Discount

15-67


bonds on January 1, 2012, for $92,639, with interest payable each

July 1 and January 1. This results in a discount of $7,361.

Journal entry on July 1, 2012, to record the interest payment and

amortization of discount is as follows:

Interest Expense 5,558

Cash 5,000

Discount on Bonds Payable 558

July 1



15-68

Illustration 15B-4


bonds on January 1, 2012, for $108,111, with interest payable

each July 1 and January 1. This results in a premium of $8,111.


Amortizing Bond Premium

15-69


Cash 5,000

Premium on Bonds Payable 676

July 1


bonds on January 1, 2012, for $108,111, with interest payable

each July 1 and January 1. This results in a premium of $8,111.


amortization of premium is as follows:


Amortizing Bond Premium

15-70

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-2


APPENDIX15CStraight-Line Amortization


15-71

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).


amortization of discount is as follows:


Cash 5,000

Discount on Bonds Payable 736

July 1



15-72

As indicated in Chapter 11, in general GAAP and IFRS define liabilities similarly.

IFRS requires that companies classify liabilities as current or non-current on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.

Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months.

Key Points

15-73

Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show non-current (long-term) liabilities before current liabilities.

Under both GAAP and IFRS, preferred stock that is required to be redeemed at a specific point in time in the future must be reported as debt, rather than being presented as either equity or in a “mezzanine” area between debt and equity.

The basic calculation for bond valuation is the same under GAAP and IFRS.

Key Points

15-74

IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP allows use of the straight-line method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record:

Cash 97,000


Key Points

15-75

The accounting for convertible bonds differs across IFRS and GAAP, Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.

Both Boards share the same objective of recording leases by lessess and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. However, GAAP for leases is much more “rules-based” with specific bright-line criteria (such as the “90% of fair value” test) to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more conceptual in its provisions. Rather than a 90% cut-off, it asks whether the agreement transfers substantially all of the risks and rewards associated with ownership.

Key Points

15-76

The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.

In addition to these projects, the FASB and IASB have also identified leasing as one of the most problematic areas of accounting. A joint project will initially focus primarily on lessee accounting.

Looking to the Future

15-77

The accounting for bonds payable is:

a) essentially the same under IFRS and GAAP.

b) differs in that GAAP requires use of the straight-line method

for amortization of bond premium and discount.

c) the same except that market prices may be different because

the present value calculations are different between IFRS and

GAAP.

d) not covered by IFRS.

IFRS Self-Test Questions

15-78

Under IFRS, if preference shares (preferred stock) have a

requirement to be redeemed at a specific point in time in the future,

they are treated:

a) as a type of asset account.

b) as ordinary shares (common stock).

c) in the same fashion as other types of preference shares.

d) as a liability


15-79

The leasing standards employed by IFRS:

a) rely more heavily on interpretation of the conceptual

meaning of assets and liabilities than GAAP.

b) are more “rules based” than those of GAAP.

c) employ the same “bright-line test” as GAAP.

d) are identical to those of GAAP.


15-80

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