15 - 1 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Long-Term Liabilities Chapter 15.

15 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Long-Term Liabilities

Chapter 15


Bonds: An Introduction

A bond is an interest bearing long-term note payable.

Bonds are groups of notes payable issued to multiple lenders called bondholders.

– principal– interest rate– interest payment dates


Types of Bonds

Term bondsTerm bonds

Serial bondsSerial bonds

Secured or mortgage bonds

Secured or mortgage bonds

Debenture bondsDebenture bonds


Bond Prices

A bond is quoted as a percent of its face value. A quote of 99½ means that a $1,000 bond

sells for $1,000 × 0.995, or $995. Bond prices are affected by...– time to maturity.– credit rating of issuer.– interest rate.


Present Value

The amount invested today receives a greater amount at a future date which is called the present value of a future amount.

It depends upon...– the amount of the future receipt.– the length of time to the future receipt.– interest rate for the period.


Issuing Bonds Payableto Borrow Money

On January 1, Granite Corp. issued $1,000,000 of 10%, 10-year bonds.

January 1Cash 1,000,000

Bonds Payable 1,000,000To issue 10%, 10-year bonds

January 1Cash 1,000,000

Bonds Payable 1,000,000To issue 10%, 10-year bonds


Issuing Bonds Payableto Borrow Money

What is the entry for the interest payment of July 1?

$1,000,000 × 10% × 1/2 = $50,000

July 1Interest Expense 50,000

Cash 50,000To record semiannual interest


Cash 50,000To record semiannual interest


Issuing Bonds and Notes PayableBetween Interest Dates

On March 31, Granite Corp. sells $1,0000,000 of 10%, 10-year bonds dated January 1.

March 31Cash 1,025,000

Bonds Payable 1,000,000Interest Payable 25,000

To issue 10%, 10-year bonds at par threemonths after original issue date

March 31Cash 1,025,000

Bonds Payable 1,000,000Interest Payable 25,000

To issue 10%, 10-year bonds at par threemonths after original issue date


Issuing Bonds and Notes PayableBetween Interest Dates

What is the July 1 interest expense? $1,000,000 × 10% × 1/4 = $25,000

June 30Interest Expense 25,000Interest Payable 25,000

Cash 50,000To pay semiannual interest

June 30Interest Expense 25,000Interest Payable 25,000

Cash 50,000To pay semiannual interest


A 10-year, $1,000,000 bond issue is sold byGranite Corp. at 99¼ on January 1.

The contract rate of interest is 10% (20 periods).

A 10-year, $1,000,000 bond issue is sold byGranite Corp. at 99¼ on January 1.

The contract rate of interest is 10% (20 periods).

Cash 992,500Discount onBonds Payable 7,500

Bonds Payable 1,000,000To issue 10%, 10-year bonds at a discount

Cash 992,500Discount onBonds Payable 7,500

Bonds Payable 1,000,000To issue 10%, 10-year bonds at a discount

Issuing Bonds Payableat a Discount


Account for basic bonds payable

transactions by the straight-lineamortization method.

Objective 1


Straight-Line Amortizationof Bond Discount

This method amortizes the bond discount by dividing it into equal amounts for each interest period.

Granite Corp. would amortize the $7,500 discount over 20 periods.

$7,500 ÷ 20 = $375 per period



Cash 50,000Discount on Bonds Payable 375

Paid semiannual interest and amortized discounton bonds payable



Paid semiannual interest and amortized discounton bonds payable

Straight-Line Amortizationof Bond Discount


Granite Corp. sold a 10%, 10-year (20 periods),$1,000,000 bond issue at a price of 101 on Jan. 1.

Granite Corp. sold a 10%, 10-year (20 periods),$1,000,000 bond issue at a price of 101 on Jan. 1.

Cash 1,010,000Bonds Payable 1,000,000Premium on Bonds Payable 10,000

Issued bonds payable at a premium

Cash 1,010,000Bonds Payable 1,000,000Premium on Bonds Payable 10,000

Issued bonds payable at a premium

Issuing Bonds Payableat a Premium


Issuing Bonds Payableat a Premium

Granite Balance Sheet(immediately after issuance of the bonds)

Granite Balance Sheet(immediately after issuance of the bonds)

Long-term liabilities:Bonds payable, 10%, due 20xx $1,000,000Premium of bonds payable 10,000

$1,010,000

Long-term liabilities:Bonds payable, 10%, due 20xx $1,000,000Premium of bonds payable 10,000

$1,010,000


July 1Interest Expense 40,500Premium on Bonds Payable 500

Cash 50,000Paid semiannual interest and amortizedpremium on bonds payable

July 1Interest Expense 40,500Premium on Bonds Payable 500

Cash 50,000Paid semiannual interest and amortizedpremium on bonds payable

Straight-Line Amortizationof Bond Premium


Granite Balance Sheet (December 31)Granite Balance Sheet (December 31)

Long-term liabilities:Bonds payable, 10%, due 20xx $1,000,000Premium on bonds payable 9,000

$1,009,000

Long-term liabilities:Bonds payable, 10%, due 20xx $1,000,000Premium on bonds payable 9,000

$1,009,000

Reporting Bonds Payable


Adjusting Entries for Interest Expense

San Antonio Corporation issued $150,000 of its 8%, 10-year bonds at a $3,000 discount on October 1, 2002.

The interest payments occur on March 31 and September 30 each year.

San Antonio closes its books on December 31. What accounts are involved?



Interest Payable: $150,000 × 8% × 3/12 = $3,000

Discount Amortization: $3,000 ÷ 10 × 3/12 = $75

Interest Expense: $3,000 + $75 = $3,075

What is the adjusting entry?



December 31, 2002Interest Expense 3,075

Interest Payable 3,000Discount on Bonds Payable 75

Accrued three months’ interest andamortized discount on bonds payable

December 31, 2002Interest Expense 3,075

Interest Payable 3,000Discount on Bonds Payable 75

Accrued three months’ interest andamortized discount on bonds payable

What is the entry on March 31, 2003?What is the entry on March 31, 2003?



March 31, 2003Interest Expense 3,075Interest Payable 3,000


Paid semiannual interest, part of whichwas accrued, and amortized three months’discount on bonds payable

March 31, 2003Interest Expense 3,075Interest Payable 3,000


Paid semiannual interest, part of whichwas accrued, and amortized three months’discount on bonds payable


Measure interest expense bythe effective-interest

method.

Objective 2


Effective-Interest Methodof Amortization

The effective-interest method keeps interest expense at the same percentage over any bond’s life.

Generally accepted accounting principles require that interest expense be measured using the effective-interest method.


Effective-Interest Method:Bond Discount

Assume that Granite Corp. issues $100,000 of its 9% bonds at a discount of $3,851, at a time when the market rate of interest is 10%.

These bonds mature in five years and pay interest semiannually.



Cash 96,149Discount on Bonds Payable 3,851

Bonds Payable 100,000To issue 10%, 10-year bonds at a discount

Cash 96,149Discount on Bonds Payable 3,851

Bonds Payable 100,000To issue 10%, 10-year bonds at a discount



What is the interest expense at the end of period one?

$96,149 × 10% × 6/12 = $4,807 What is the interest payment at the end of

period one? $100,000 × 9% × 6/12 = $4,500 $4,807 – $4,500 = $307 amortization



End of Carrying Interest CashPeriod Value Expense Paid AmortizationIssue 96,149Date 1 96,456 4,807 4,500 307 2 96,779 4,823 4,500 323 3 97,118 4,839 4,500 339 4 97,474 4,856 4,500 356



Effective-Interest Method:Bond Premium

Assume the Granite Corp. issues a $100,000, 5-year, 9% bond to yield 8%, at a premium of $4,100.

The first period interest expense is computed as follows:

$104,100 × 8% × 6/12 = $4,164






Account for retirement

of bonds payable.

Objective 3


Retirement of Bonds Payable

To retire a bond early, the issuer can ...– purchase the bonds in the open market, or– exercise a call option. A call option is a clause that allows the bond

issuer to redeem the bonds at a specified price (usually a few points over par) on or after a specified date.

The journal entry is the same in either case.


Retirement of Bonds Payable Example

$500,000 of 12% bonds with an unamortized premiumof $20,000 are purchased for $498,000 and retired.

Bonds Payable 500,000Premium of Bonds Payable 20,000

Cash 498,000Extraordinary Gain on Retirement of Bonds 22,000Retired bonds payable

Bonds Payable 500,000Premium of Bonds Payable 20,000

Cash 498,000Extraordinary Gain on Retirement of Bonds 22,000Retired bonds payable


Account for conversion

of bonds payable.

Objective 4


Convertible Bonds and Notes

Convertible bonds and notes give the holder the option of exchanging the bond for a specified number of shares of common stock.

If a bond issue or a note payable is converted into common stock, stockholders’ equity is increased by the carrying amount of the bonds converted.


Current Portion of Long-Term Debt

Serial bonds and serial notes are payable in installments.

The portion payable within one year is a current liability.

The remaining debt is long term.


Mortgage Notes Payable

A mortgage is a security agreement that pledges certain assets as collateral for a note.

If it is not paid in a timely fashion, the borrower will have to transfer title to the lender.

Mortgage notes are usually paid in monthly installments.


Show the advantages anddisadvantages of

borrowing.

Objective 5


•Equity financing createsno liabilities and no

interest burden.•It is less risky to theissuing corporation.

•It may dilute ownershipinterest of existing

shareholders.

•Equity financing createsno liabilities and no

interest burden.•It is less risky to theissuing corporation.

•It may dilute ownershipinterest of existing

shareholders.

•Debt financing doesnot dilute control.

•It usually results in higherearnings per share.•It reduces total net

income and may imposefinancial restrictions

on the company.

•Debt financing doesnot dilute control.

•It usually results in higherearnings per share.•It reduces total net

income and may imposefinancial restrictions

on the company.

Issuing Bonds versus Stock


Advantage of Issuing Bondsversus Stock Example

Suppose that Granite Corp., with net income of $300,000 and with 100,000 shares of common stock outstanding, needs $500,000 for expansion.

Money can be borrowed at 10% interest. The income tax rate is 40%.



50,000 shares of common stock can be issued for $500,000.

Management believes that the new cash can be invested in operations to earn income of $200,000 before interest and taxes.

Should the company borrow the money or issue additional common stock?



Borrow $500,000Borrow $500,000

Expected net income on the new project $200,000Interest expense – 50,000Project income before taxes $150,000Income tax expense – 60,000Project net income $ 90,000Net income before expansion $300,000Total income $390,000

Expected net income on the new project $200,000Interest expense – 50,000Project income before taxes $150,000Income tax expense – 60,000Project net income $ 90,000Net income before expansion $300,000Total income $390,000



Issue 50,000 shares of common stock at $10 per shareIssue 50,000 shares of common stock at $10 per share

Expected net income on the new project $200,000Income tax expense – 80,000Project net income $120,000Net income before expansion $300,000Total income $420,000

Expected net income on the new project $200,000Income tax expense – 80,000Project net income $120,000Net income before expansion $300,000Total income $420,000



Borrow $500,000:$390,000 ÷ 100,000 = $3.90 earnings per share

Borrow $500,000:$390,000 ÷ 100,000 = $3.90 earnings per share

Issue $500,000 of common stock:$420,000 ÷ 150,000 = $2.80 earnings per share

Issue $500,000 of common stock:$420,000 ÷ 150,000 = $2.80 earnings per share


Account for lease liabilities

and pension liabilities.

Objective 6


Leases

A lease is a rental agreement that allows the lessee use of an asset without a large cash down payment.

For accounting purposes there are two types of leases:

1 Operating lease2 Capital lease


Capital Lease

Any one of the following qualifies an agreement as a capital lease:

It transfers title at the end of the term. It contains a bargain purchase option. The term covers 75% or more of the

estimated useful life of the asset. The present value of the lease exceeds 90%

of the market value of the asset.


Pension and PostretirementBenefits Liabilities

As the employees work, the company accrues the expense and the liability of providing benefits during retirement.

Debit Pension Expense and credit Cash. At the end of each period, the company

compares the fair market value of the pension plan assets with the accumulated benefit obligation.


Pension and PostretirementBenefits Liabilities

The accumulated benefit obligation is the amount of promised future pension payments to retirees.

If the plan is underfunded, the excess liability must be recorded as a long-term pension liability.


Appendix

What is the present value of $4,500 interest to be received for 10 periods at 5%?

The present value annuity table indicates that 7.722 is the factor for 10 periods at 5%.

The present value of the future interest is $4,500 × 7.722 = $34,749.


Appendix

What is the present value of a lump sum of $100,000, 10 periods from now at 5%?

The present value table indicates that .614 is the factor to be used in determining the value of $100,000 to be received 10 periods from now at 5%.

$100,000 × .614 = $61,400


Total present value = $34,749 + $61,400 = $96,149Total present value = $34,749 + $61,400 = $96,149

What is the total present value of these amounts?What is the total present value of these amounts?

Appendix


Appendix

What is the present value of $4,500 interest to be received for 10 periods at 4%?

The present value annuity table indicates that 8.111 is the factor for 10 periods at 4%.

The present value of the future interest is $4,500 × 8.111 = $36,500.


Appendix

What is the present value of a lump sum of $100,000, 10 periods from now at 4%.

The present value table indicates that .676 is the factor to be used in determining the value of $100,000 to be received 10 periods from now at 4%.

$100,000 × .676 = $67,600


Appendix

Total present value = $36,500 + $67,600 = $104,100Total present value = $36,500 + $67,600 = $104,100

What is the total present value of these amounts?What is the total present value of these amounts?


End of Chapter 15

15 - 1 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Long-Term Liabilities Chapter 15.

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