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ACCT 100 Chapter 10 Current and Long-Term Liabilities

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Chapter 10. Current and Long-Term Liabilities. Objectives of the Chapter. Discuss the accounting for major types of current liabilities. Discuss the issuance of bonds (i.e., why bonds are issued; the issuing procedures of bonds, etc.) - PowerPoint PPT Presentation

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Page 1: Chapter 10

ACCT 100

Chapter 10

Current and Long-Term Liabilities

Page 2: Chapter 10

Objectives of the Chapter

1. Discuss the accounting for major types of current liabilities.

2. Discuss the issuance of bonds (i.e., why bonds are issued; the issuing procedures of bonds, etc.)

3. Prepare the entries for the issuance of bonds and the recording of the subsequent interest payments.

4. Discuss the accounting for bond retirement and bond conversion.

5. Debt to total assets ratio and time interest earned ratio. 2

Page 3: Chapter 10

Current and Long-Term Liabilities 3

Liabilities

Legal obligations require the future payments of cash or services as a result of past transactions. In this chapter we look at.

I. current liabilities as a result of business transactions, and

II. long-term liabilities (i.e., bonds payable).

Page 4: Chapter 10

Current and Long-Term Liabilities 4

Current Liabilities:

Obligations must be fulfilled in one year or one operating cycle, whichever is longer.

Page 5: Chapter 10

Current and Long-Term Liabilities 5

I. Current Liabilities as a Result of Business Transactions:

A. Current liabilities with definite amount

B. Estimated liabilities

Page 6: Chapter 10

Current and Long-Term Liabilities 6

A. Current Liabilities with Definite Amount

a. Accounts Payable (A/P)

b. Short-Term Notes Payable (N/P)

c. Sales Tax Payable

d. Current maturity portion of long-term liability (i.e., bonds payable)

e. Accrued Liabilities (i.e., interest payable)

f. Payroll Taxes withholdings (payroll liabilities)

g. Unearned Revenues

Page 7: Chapter 10

Current and Long-Term Liabilities 7

a. Accounts Payable:

Amounts owed to suppliers for products or services purchased on account.

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Current and Long-Term Liabilities 8

b. Short-Term Notes Payable:

Notes payable due in one year or one operating cycle whichever is longer.

Companies often issue notes to borrow money or to purchase inventory or other assets.

If the note payable is an interest bearing note, an accrued interest should also be recognized at the end of the period, if there is any.

Page 9: Chapter 10

Current and Long-Term Liabilities 9

Example of A Transaction Involving N/P:

J. E.

Inventory XXX

N/P XXX

or

Cash XXX

N/P XXX

Page 10: Chapter 10

Current and Long-Term Liabilities 10

b. Short-Term Notes Payable: (contd..)

Short-term N/P can also be issued at discount to borrow cash from a bank. Bank will subtract the interest amount from the note’s face value and the borrower will receive the net amount.

Page 11: Chapter 10

Current and Long-Term Liabilities 11

Example:

P&G discounts a $200,000, 90-day note payable to its bank on 12/1/x8. The bank charges 12% annual interest on the borrowing. P&G will receive $200,000 - 200,000 x 12% x 90/360 = 200,000 - 6,000 =$194,000.

Page 12: Chapter 10

Current and Long-Term Liabilities 12

Example (coned)

P&G’s entries to record the discounting of the note and related entries are as follows:

12/1/x8 Cash 194,000

Discount on N/P 6,000

N/P200,000

12/31/x8 Interest Exp.* 2,000

Discount on N/P2,000

* $200,000 x 12% x 30/360 = 2,000

Page 13: Chapter 10

Current and Long-Term Liabilities 13

Example (contd.)

B/S presentation:

B/S (12/31/x8)

Current Liabilities:

N/P - Short-term 200,000

Dis. on N/P (4,000)

$196,000

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Current and Long-Term Liabilities 14

Example (contd.)

At maturity (3/1/x9), the P&G’s entries are:

3/1/x9 Int. Exp.* 4,000

Dis. on N/P4,000

* $200,000 x 12% x 60/360 = $4,000

3/1/x9 N/P 200,000

Cash200,000

Page 15: Chapter 10

Current and Long-Term Liabilities 15

c. Sales Taxes Payable:

Sales taxes are taxes levied by states on retail sales, not on manufacturers (i.e., GE, GM, etc).

Every state, except Alaska, Delaware, Montana, New Hampshire, and Oregon, levies state sales taxes on retail sales.

The rate varies state by state (for example, California has a statewide sales tax at 7.25% with a local supplementary tax for up to 8.75%).

Page 16: Chapter 10

Current and Long-Term Liabilities 16

c. Sales Taxes Payable: (contd.)

Retailers charge their customers the sales taxes in addition to the price of the merchandise.

The retailers have to forward the collected sales taxes to the state at regular intervals.

Page 17: Chapter 10

Current and Long-Term Liabilities 17

Example

Assume that the 12/22/x8 sales of Macy’s in California totaled $2,000,000. The state tax rate is 8.25%. The business would record the day’s sales as follows:Cash 2,165,000

Sales Revenue 2,000,000Sales Taxes Payable 165,000

Page 18: Chapter 10

Current and Long-Term Liabilities 18

Example

When forwarding the collected sales taxes to the state, the following entry will be recorded:Sales Taxes Payable 165,000

Cash165,000

Page 19: Chapter 10

Current and Long-Term Liabilities 19

d. Current Portion of Long-Term Debt:

Some bonds payable are paid in installments. The current maturity portion of a long-term debt should be reported as a current liability.

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Current and Long-Term Liabilities 20

e. Accrued Liabilities:

Expenses incurred but have not yet been paid by the company.

If these liabilities are due within one year or one operating cycle whichever is longer, they should be reported as current liabilities.

Page 21: Chapter 10

Current and Long-Term Liabilities 21

f. Payroll and Payroll Taxes Payable

Include salary payable to employees, employee income taxes payable (employee income taxes withholdings), FICA taxes payable (employee’s FICA taxes withholdings by the employer),etc.

Page 22: Chapter 10

22

Example

Salaries Expense 50,000

Employee FICA Taxes Payable* 3,825

Federal I/T Payable 12,500

State I/T Payable 4,000

Employee Union Dues Payable 250

Salaries Payable` 29,425For 2008, FICA (Federal Insurance Contributions Act) tax includes 6.2%

and 1.45% of Social Security and Medicare taxes, respectively, on the first $102,000 gross income. This payroll tax is imposed by the federal government on both employees and employers to fund Social security and Medicare.

* 50,000 x (6.2% + 1.45%) = 3,825

Page 23: Chapter 10

Current and Long-Term Liabilities 23

g. Unearned Revenues:

Revenues collected in advance before providing services.

Example: Assume that New Magazine collects $300 subscription fee in advance from a subscriber. The entry will be:

Cash 300

Unearned Subscription Revenue300

Page 24: Chapter 10

Current and Long-Term Liabilities 24

Estimated Liabilities

Liabilities exist but the amount is unknown (i.e., property taxes, warranty obligations, coupon and premium obligations …)

Page 25: Chapter 10

Current and Long-Term Liabilities 25

Estimated Liabilities (contd.)

a. Warranty Obligations (Product Warranty)

b. Premium and Coupon Obligations

c. Estimated Vacation Pay Liability

Page 26: Chapter 10

Current and Long-Term Liabilities 26

a. Warranty Obligations

These obligations are associated with the sales of the period and are recognized at the end of the period.

Journal Entry:Warranty Expenses xxx

Estimated Warranty Liabilities xxx

When warranty services are provided:

Estimated warranty liabilities xxx

Cash (or Inventory) xxx

Page 27: Chapter 10

Current and Long-Term Liabilities 27

b. Premium and Coupon Obligations

Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made.

Journal Entry

Premium (or Coupon) Expenses xxx

Estimated Premium Claims

(or coupon) outstandingxxx

Page 28: Chapter 10

Current and Long-Term Liabilities 28

b. Premium and Coupon Obligations (contd.)

When premium (or coupon) are claimed: Journal EntryEstimated Premium Claims (coupon) outstanding xxx Inventory

xxx

* If the actual redemption of coupons (or premiums) is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year. (APB Opinion No. 20)

Page 29: Chapter 10

Current and Long-Term Liabilities 29

c. Estimated Vacation Pay Liability:

Example:

12/31/X1

Vacation Pay Expense xxx

Estimated Vacation Pay Liability xxx

2/1/X2

Estimated Vacation Pay Liability xxx

Cash xxx

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Current and Long-Term Liabilities 30

II. Long-Term Liabilities

1. Present value concept

2. Annuity

3. Topics of long-term liabilities

Page 31: Chapter 10

Current and Long-Term Liabilities 31

1. Present Value Concept

Present value of $1 is the value today of $1 to be received at some future date, given a specific interest rate.

Page 32: Chapter 10

Current and Long-Term Liabilities 32

Example 1

What is the present value of $100 to be received a year from now given the annual market interest rate is 10%?

P.V. * (1 + 10%) = $100

P.V. = $100/1.1

= $100 x 0.9091

= $90.91

Page 33: Chapter 10

Current and Long-Term Liabilities 33

Example 2

What is the present value of $100 to be received two years from now given the annual interest rate is 10%?

P.V * (1-10%) * (1+10%) = $100P.V * (1-10%)2 = $100P.V. * 1.21= $100P.V. = $100 / 1.21

= $100 * 0.8264= $82.64

Page 34: Chapter 10

Current and Long-Term Liabilities 34

2. Annuity

Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods.

Receiving $100 every year for the following 5 years. (period = 1 year) (starting a year from now)

$100 $100 $100 $100 $100

1 year

Page 35: Chapter 10

Current and Long-Term Liabilities 35

2. Annuity (contd.)

Present Value (P.V.) of an annuity:

Using the example above given 10% Interest rate:

P.V. of the first $100 = $100 * 0.9091 = $90.91

P.V. of the second $100 = $100 * 0.8264 = $82.64

P.V. of the third $100 = $100 * 0.7513 = $75.13

P.V. of the fourth $100 = $100 * 0.6830 = $68.30

P.V. of the fifth $100 = $100 * 0.6209 = $62.09

Total 3.7907 $379.07

Page 36: Chapter 10

Current and Long-Term Liabilities 36

2. Annuity (contd.)

The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now =>

$100 3.7907 = $379.07

Can be obtained from the annuity table under 10%, 5 periods.

Page 37: Chapter 10

Current and Long-Term Liabilities 37

3. Topics of Long-Term Liabilities

A. Corporate bonds

B. Convertible bonds and notes

C. Other long-term liabilities

Page 38: Chapter 10

38

A. Corporate Bonds

Bonds are securities issued by a corporation to borrow money from the public.

The corporation will receive cash when bonds are issued.

The face value (principal) of the bonds must be repaid to the bondholders on the maturity date.

the bond issuers will pay interests to the bondholders periodically (i.e., semi-annually .

Page 39: Chapter 10

39

Topics of Bonds

The procedures of bond issuance. Units of bonds. Types of bonds. Determination of bond price. Present value of bonds. Issuance of bonds at face value, at a

discount or at a premium. Accounting for bonds payable. Bond retirement before maturity.

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40

The Procedures of Bond Issuance

1. Receive the approval from the board of directors and stockholders.

2. Draw a bond indenture* and print bond certificates**.

3. Make a public announcement of its intent to sell the bonds on a particular date.

*a written agreement between the issuer and bondholders (a legal document) with terms such as stated interest rate, the maturity date, the convertibility, the trustee, etc.

**provides information such as bond issuer, face value, stated interest rate, the maturity date, etc. See Illustration 11-10 for an example.

Page 41: Chapter 10

Current and Long-Term Liabilities 41

The Procedures of Bond Issuance (contd..)4. Negotiate the appropriate selling price with

the underwriters based on the terms of bond issue (i.e., the stated interest rate), the general bond market conditions, the risk of the bonds and the expected state of the economy.

5. The underwriter purchases the bonds from the issuing company and resells them to the clients or the underwriter may sell the bonds for the company for a commission.

Page 42: Chapter 10

Current and Long-Term Liabilities 42

Units of Bonds

Bonds are usually issued at the unit of $1,000 or a multiple of $1,000.

Price of bonds: stated at 100s i.e., $1,000 issued at 98issuing price = $1,000 * 0.98 = $980

Page 43: Chapter 10

Current and Long-Term Liabilities 43

Types of Bonds

On the basis whether the bonds are secured:

Secured bonds (with assets pledged) Unsecured bonds (Debentures)

On the basis of how the bonds mature: Term Bonds Serial Bonds

Page 44: Chapter 10

Current and Long-Term Liabilities 44

Determination of Bond Price

The obligations of bond issuers:(1) to pay the principle (the face value)

when bonds mature on the maturity date.(2) to pay stated (or contractual) interest

periodically (i.e., semiannually or annually) over the life the bond.

Page 45: Chapter 10

Current and Long-Term Liabilities 45

Present Value of Bonds

Bond Price: equals the present value (PV) of the bond.

PV of the bond equals the sum of

(1) the present value of the principal received on the maturity date plus

(2) the present value of the periodic interests (an annuity).

Page 46: Chapter 10

Current and Long-Term Liabilities 46

Present Value of Bonds

Discount rate = effective rate = market interest rate

This rate depends on the riskiness of the issuer and the economic condition.

In general, a higher risk will result in a higher market interest rate.

Page 47: Chapter 10

Current and Long-Term Liabilities 47

Bonds Issued at Face Value

When the stated interest rate equals the market interest rate, the bond price will equal the face value of the bond.

Page 48: Chapter 10

Current and Long-Term Liabilities 48

Example 1

Page company issued a 5-year term bond with face amount $100,000 and stated annual interest rate 10%.

The interests are paid semiannually. Assume that the annual market interest

(effective rate) demanded by investors for bonds of this level of risk is also 10%.

What is the present value of the bond?

Page 49: Chapter 10

49

Example 1 (stated rate = market interest rate) (1)P.V. of the principal ($100,000 mature in

5 years, semiannual discount rate 5%, 10 periods): $100,000 * 0.6139 = $61,390

(2) P.V. of the stated interests received semiannually for 10 periods (annuity, semiannual discount rate = 5%, 10 periods) 5,000* x 7.7217 = 38,608.5* The semiannual stated interest paid = $100,000 x 10% x 1/2 = $5,000

Page 50: Chapter 10

Current and Long-Term Liabilities 50

Example 1 (contd.)

The P.V. of the bond = the sum of (1) and (2)(1) + (2) = $61,390 + 38,608.5 = $100,000

Page 51: Chapter 10

Current and Long-Term Liabilities 51

Example 1 (contd.)

Therefore, when the stated rate equals the effective rate (the market interest rate), the bond price (the P.V. of bonds) equals the face value. (state rate=5%, effective rate =5%)

J.E. (when bonds are issued at face value)

Cash 100,000

Bonds payable100,000

Page 52: Chapter 10

Current and Long-Term Liabilities 52

Bonds Issued at A Discount

When the stated interest rate is less than the market interest rate, the present value of a bond will be less than its face value.

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Current and Long-Term Liabilities 53

Example 2 (stated rate <effective rate)

Use the same information as in example 1 on p47, except that the annual market interest rate is 12%. What is the semiannual interest received

by bondholders? $100,000 x 10% * 1/2 = $5,000

What is the discount rate used to compute the P.V. of the bond?

6% (the semiannual effective rate)

Page 54: Chapter 10

Current and Long-Term Liabilities 54

Example 2 (contd.)

Compute the present value of the bond: Since the interests are paid semiannually, the

discount rate will be 6% with 10 periods.(1) P.V. of the principal = $100,000 x .5584 = $55,840

P.V. table, 6%, 10periods

(2) P.V. of the semiannual interests:$5,000 x 7.3601 = 36,800.5

Annuity table, 6%, 10periods

Page 55: Chapter 10

Current and Long-Term Liabilities 55

Example 2 (contd.)

Annuity table, 6%, 10periods

P.V. of the bond = (1) + (2) = $55,840 + 36,800.5

= $92,640.5

Page 56: Chapter 10

Current and Long-Term Liabilities 56

Example 2 (contd.)

$92,640.5 < $100,000 (Discount = $7359.5)P.V. of bond < Face vale

=> when the stated rate is less than the effective rate (i.e., 5% < 6%), the P.V. of the bond will be less than the face value.

Page 57: Chapter 10

Current and Long-Term Liabilities 57

Example 2 (contd.)

J.E. (when bonds are issued at discount)

Cash 92,640.5Discount on Bonds 7,359.5

Bonds Payable 100,000(state rate =5%, effective rate =6%)

Page 58: Chapter 10

Current and Long-Term Liabilities 58

Bonds Issued at Premium

When the stated interest rate is higher than the effective interest rate demanded by the investors for the level of the risk of the bonds, the present value of the bonds would be greater than its face value.

Page 59: Chapter 10

Current and Long-Term Liabilities 59

Example 3 (stated rate > effective rate)

Use the same information as in example 1 on p47, except that the market interest rate is 8%. (the stated interest rate is still at 10%)

What is the semiannual interest received by bondholder?

$100,000 x 10% x 1/2 = $5,000

Page 60: Chapter 10

Current and Long-Term Liabilities 60

Example 3 (contd.)

What is the discount rate used to compute the P.V. of the bond?

4% (the semiannual effective rate when interests are paid semiannually) (10 periods)

Page 61: Chapter 10

Current and Long-Term Liabilities 61

Example 3 (contd.) (stated rate < effective rate)

Compute the P.V. of the bond:(1) P.V. of the principal:

$100,000 x 0.6756 = $67,560

(2) P.V. of the semiannual interest: $5,000 x 8.1109 = $40,554.5

P.V. of the bond = (1) + (2)= $67,560 + 40,554.5 = $108,114.5

Page 62: Chapter 10

Current and Long-Term Liabilities 62

Example 3 (contd.)

J.E. (When Bonds are issued at Premium)

Cash 108,114.50

Bonds Payable 100,000.00

Premium on Bonds Payable 8,114.50

(state rate=5%, effective rate =4%)

Page 63: Chapter 10

Current and Long-Term Liabilities 63

Accounting for Bonds Payable A premium account: an adjunct account

to the Bonds Payable account and is shown as an addition to the bonds payable account.

A discount account: a contra account to the bonds payable and is shown as a deduction from the bonds payable account.

Page 64: Chapter 10

Current and Long-Term Liabilities 64

Accounting for Bonds Payable Book value (carrying value) of the bonds

issued =

the face value plus any unamortized premiums or minus any unamortized discounts.

Page 65: Chapter 10

Current and Long-Term Liabilities 65

Accounting for Bonds Payable (contd..) The information of example 1 is summarized

below with some additional information:

Issuing Company: Page CompanyStated Interest: 10% (annual)Effective Interest: 10% (annual)Date of Issuance: 2/1/x1(sold on

2/1/x1)Date of Maturity: 2/1/x6Interest Payment Dates: 2/1 and 8/1Face Value: $100,000P.V. of the Bond: $100,000

Page 66: Chapter 10

Current and Long-Term Liabilities 66

Accounting for Bonds Payable (contd.)

J.E.

2/1/x1 Cash 100,000B/P100,000

8/1/x1 Interest Expense 5,000Cash5,000

Page 67: Chapter 10

Current and Long-Term Liabilities 67

Accounting for Bonds Payable (contd.)

12/31/x1 Adjusting entry for 5-month interest expense occurred but not paid. The interest payment dates are 2/1 and 8/1).

Interest Expense 4,167Interest payable4,167

Page 68: Chapter 10

Current and Long-Term Liabilities 68

Accounting for Bonds Payable (contd.)

2/1/x2 Interest Expense 833Interest Payable 4,167

Cash 5,0008/1/x2 Interest Expense 5,000

Cash 5,00012/31/x2 Adjusting entry for the 5-month unrecorded interest expense.

Interest Expense 4,167Interest payable 4,167

Page 69: Chapter 10

Current and Long-Term Liabilities 69

Accounting for Bonds Payable (contd.)2/1/x3 (Interest payment)8/1/x3 (Interest payment) 12/31/x3 (Adjusting)

12/31/x5 (Adjusting)2/1/x6 Interest Expense 833

Interest payable 4,167Cash5,000

Bonds Payable 100,000cash100,000

(Bond Retired at Maturity)

...

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70

Accounting for B/P When Bonds Are Issued at A Discount The information of example 2 on p52 is

summarized below with some additional information:

Stated Interest = 10% (annual)

Effective Interest = 12% (annual)Date of Issuance = 1/1/x1 (sold on 1/1/x1)Date of Maturity = 1/1/x6Interest Payment Dates = 6/30 and 12/31Face Value = $100,000P.V. of the Bond = 92,640.50

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Current and Long-Term Liabilities 71

Accounting for B/P When Bonds Are Issued at A Discount (contd.)

Discount = $100,000 - 92,640.5 = 7,359.50

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Amortization of Bond Discount

Amortization methods:1. Straight-Line Method: the Discount would be

amortized equally over the life of the bond(i.e., Amortization over 10 periods).$7359.50/10 = $735.95Therefore, the interest expense for every period is

$5,000 + 735.95 = $5,735.95Semiannual the amortized DiscountInterest Payment

2. Effective - Interest Method:Interest Expense = P.V. of Bond x effective rate

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1.Amortization of Bond Discount – Straight-Line Method

J.E (Bonds are issued at discount and use the Straight-Line method to amortize the discount)

1/1/x1 Cash 92640.50 Discount on Bonds payable 735.95

B/P 100,000

6/30/x1 Interest Expense 5,735.95Cash 5000 *Discount on Bonds Payable 735.95 **

12/31/x1 Interest Expense 5,735.95 ***Cash 5,000Discount on Bonds Payable 735.95

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Current and Long-Term Liabilities 74

Amortization of Bond Discount – Straight-Line Method (contd..)

* Interest Payment = semiannual interest = $100,000 x 10% x 1/2** Amortization of Discount over 10 periods (7359.50/10)*** Interest Expense = Interest Payment + Amortized Discount.

6/30/x2 Same J.E. as recorded on 6/30/x112/31/x2 Same J.E. as recorded on 6/30/x16/30/x3 Same J.E. as recorded on 6/30/x112/31/x3 Same J.E. as recorded on 6/30/x16/30/x4 Same J.E. as recorded on 6/30/x112/31/x4 Same J.E. as recorded on 6/30/x16/30/x5 Same J.E. as recorded on 6/30/x1

Page 75: Chapter 10

Current and Long-Term Liabilities 75

Amortization of Bond Discount – Straight-Line Method (contd..)

12/31/x5 Interest Expense 5,735.95

Cash 5,000.00

Discount on Bonds Payable 735.95

1/1/x6 B/P 100,000

Cash 100,000

Page 76: Chapter 10

Current and Long-Term Liabilities 76

Amortization of Bond Discount – Straight-Line Method (contd..)

Interest Expense from 1/1/x1 to 12/31/x5= $ 5,735.95 * 10= $5,7,359.50= $50,000 + 7,359.5

Interest payments Discount on Bonds

Discount on Bonds1/1/x1 7,359.50 735.95 6/30/x1

735.95 12/31/x1 735.95 6/30/x2

735.95 12/31/x5

....

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Long-Term Liabilities77

2.The Effective Interest Method to Amortize Bond Discount

Use the example on p69 and use the effective interest method to amortize the discount.

Interest Payment = $100,000 * 5%= $5,000

Interest Expense = P.V. of Bond at the Beginning of the period the Effective Rate

Amortized Discount = Interest Expense - Interest payment

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Long-Term Liabilities78

Effective Interest Amortization Table-bond are issued at a discount

1 2 3 4 5 6

PeriodP.V at Beg. Of Period

Interest Expense (1) * 6%

Cash (Interst)

payments

Amortized Discount (2) - (3)

Unamortized Discount

(5)-(4)

B.V. at end of Period

$100,000 - (5)

0 - - - - $7,359 $92,6411 92,641 $5,558 $5,000 $558 $6,801 93,1992 93,199 5,592 $5,000 592 6,209 93,7913 93,791 5,627 $5,000 627 5,582 94,4184 94,418 5,665 $5,000 665 4,917 95,0835 95,083 5,704 $5,000 704 4,213 95,7876 95,787 5,704 $5,000 747 3,466 96,5147 96,534 5,792 $5,000 792 2,674 97,3268 97,326 5,840 $5,000 840 1,834 98,1669 98,166 5,890 $5,000 890 944 99,05610 99,056 5,944 $5,000 944 - 100,000

Total $57,359 $50,000 7,359

Page 79: Chapter 10

Long-Term Liabilities79

The Effective Interest Method to Amortize Bond Discount (Contd.)

Journal Entries :1/1/x1 Cash 92,641

Discount on B/P 7,359 B/P 100,0006/30/x1 Interest Expense 5,558(period 1) Cash 5,000

Discount on B/P 55812/31/x1 Interest Expense 5,592(period 2) Cash 5,000

Discount on B/P 592

Page 80: Chapter 10

Long-Term Liabilities80

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)

6/30/x2 Interest Expense 5,672Cash 5,000Discount on B/ P 672

::

6/30/x5 Interest Expense 5,890Cash 5,000Discount on B/P 890

12/31/x5 Interest Expense 5,944Cash 5,000Discount on B/P 944

1/1/x6 B/P 100,000Cash 100,000

Page 81: Chapter 10

Long-Term Liabilities81

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)

Discount on Bonds Payable

1/1/x2 7,359 558…6/30/x1

592…12/31/x1

672…6/30/x2

890…6/30/x5

944…12/31/x5

0

Interest Expense over 10 periods =>

Period 1 $5,558

Period 2 $5,592

period 3 $5,627

Period 9 $ 5,890

Period 10 $ 5,944

$57,359

$57360= $50,000 + 7,359

Page 82: Chapter 10

82

Accounting for Bonds Payable (Contd.)

APB Opinion 21 requires the use of the effective interest method to amortize premium or discount when two amortization methods generate significant different results.

Expenditures connected with a bond issue (legal fees, printing costs, etc.) should be deferred and amortized as expense over the life of the bond using the straight-line method.

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Current and Long-Term Liabilities 83

Accounting for B/P When Bonds Are Issued at A Premium Information of example 3 is summarized

below with some additional information:

Stated Interest Rate (annual) = 10%

Effective Interest Rate (annual) = 8%

Date of Issuance = 1/1/x1 (sold on 1/1/x1)

Date of Maturity = 1/1/x5

Interest Payment Dates = 6/30 and 12/31

Face Value = $100,000

P.V. of the Bond = $108,115

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Current and Long-Term Liabilities 84

Accounting for B/P When Bonds Are Issued at A Premium (contd.)Premium = $108,114.5 - 100,000 =

$8,114.5 The premium would decrease the

interest expense and should be amortized over 10 periods.

Using the straight-lint method to amortize the premium, $811.45 would be amortized every period.

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Current and Long-Term Liabilities 85

Accounting for B/P When Bonds Are Issued at A Premium (contd.)J.E (Amort. = Straight-Line method)

1/1/x1 Cash 108,114.5 B/P 100,000

Prem. on B/P 8,114.56/30/x1 Prem.on B/P 811.45

Int. Exp. 4,188.55 Cash5,000

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Current and Long-Term Liabilities 86

Accounting for B/P When Bonds Are Issued at A Premium (contd.)

12/31/x1 Premium on Bonds Payable 811.45Interest Expense 4,188.55

Cash 5,000 6/30/x5 Premium on Bonds Payable 811.45 Interest Expense 4,188.55

Cash 5,000....

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Current and Long-Term Liabilities 87

Accounting for B/P When Bonds Are Issued at A Premium (contd.)

12/31/x5 Premium on Bonds Payable 811.45

Interest Expense 4,188.55

Cash5,000

1/1/x5 B/P 100,000

Cash100,000

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Current and Long-Term Liabilities 88

Accounting for B/P When Bonds Are Issued at A Premium (contd.)

Premium on Bonds6/30/x1 811.45 8114.5---1/1/x112/31/x1 811.45

6/30/x5 811.4512/31/x5 811.45

0

Interest Expense for 10 periods = $4188.55 x 10 = 41,885.5

41,885.5 = 50,000 - 8,114.5

Premium on Discount

Total Interest(cash) payment

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89

Bond Retirements Before Maturity (i.e., Callable Bonds)

Use example 2 (issued at a Discount; using straight-line amortization)

Bond Retired at the end of period 3 for $98,000.

Discount on Bonds 7,359 736…Period 1 round to the dollar from

$735.9

736…Period 2 736…Period 3 5,151

Unamortized discount at then end of period 3 PV of the Bond = 100,000 - 5,151 = 94,849

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Current and Long-Term Liabilities 90

Bond Retirements Before Maturity (contd.)B/P 100,000

Loss on Retirement of Bonds* 3,151

Discount on Bonds Payable5,151

Cash98,000

*or Loss on bond redemption

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Current and Long-Term Liabilities 91

Convertible Bonds –Converting Bonds into Common Stock At conversion, the carrying amount (the

book value) of the bonds is transferred from a liability to stockholders’ equity.

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Current and Long-Term Liabilities 92

Example (Converting Bonds into Common Stock)

MI Corp. has convertible bonds outstanding with a carrying amount (book value) of $10.5 million.

The maturity value (face amount) of the bonds is $12 million.

The bondholders convert the bonds into 250,000 shares of the company’s $2 par common stock on 3/8/x7

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Current and Long-Term Liabilities 93

Example (contd.)

3/8/x7 ( $ in millions)

Bonds Payable 12

Discount on Bonds Payable 1.5

Common Stock 0.5

Paid-in Capital in excess of Par-Common 10

Book value of bonds = $12-1.5= $10.5 (million)

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Current and Long-Term Liabilities 94

Corporate Bond Listing*

Corporate bond listings usually include the coupon (i.e., the stated interest), maturity date, last price traded, the current yield and the volume traded.

Examples of Corporate bond listings:Bonds Cur. Yld. Vol Close Net Chg.

BosCelts 6s38 9.2 22 65 3/8 + 1/4

PacBell 6 5/8 34 6.7 5 99 1/8 - 1/8* Source: http://www.investinginbonds.com/learnmore.asp?

catid=3&id=45

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Current and Long-Term Liabilities 95

Bond Current Yield and Yield-to-Maturity*

Current Yield = Annual Stated Interest/Close Price

BosCelts 60/653.75 = 9.2%

PacBell 66.25/991.25= 6.7%

Yield- to-Maturity: The discount rate ( r )to equate all future cash flows (i.e., stated interest and the par value) of the bond with the present value of the bond.

BosCelts: 653.5 = 60(1+r)-1 +60 (1+r) -2 +….+

60(1+r)-28 +1,000x(1+r)-28

2038-2010 = 28• YTM is a better measure of bond returns than the current yield.

* Source: http://www.moneychimp.com/articles/finworks/fmbondytm.htm

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Accounting for Long-Term Notes Payable Companies often borrow money from banks

by issuing a long-term note with specific assets as security for the loan.

This note payable is referred to as mortgage notes payable.

The interest of the note could be either fixed or adjustable.

The terms of the note typically require the borrow to make installment payments over the term of the loan.

96

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Long-Term Notes Payable (contd.)

Each payment will include:1)the interest on the unpaid balance of the loan, and 2) a reduction of loan principal.

Since the stated interest rate on the note is the market interest rate, the borrower will receive cash equals the face value of the note (no discount or premium).

97

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Long-Term Notes Payable –An Example

Example: (Source: Financial Accounting by Weygandt, Kimmel and Kieso, p493 )

Porter Tech. Inc. issues a $500,000, 12%, 20-year mortgage note on 12/31/2008 to obtain needed finance for a new research lab. The terms require a semiannual installment payments of $33,231. The installment payment schedule for the first two years is as follows:

98

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Long-Term Notes Payable (contd.)

Semiannual annual int. period

Cash payment

Interest Expense

Reduction of Principal

Principal Balance

12/31/08 $500,000

6/30/09 $33,231 $30,000 $3.321 496,769

12/31/09 $33,231 29,806 3,425 493,344

06/30/10 $33,231 29,601 3,630 489,714

12/31/10 $33,231 29,383 3,848 485,866

99

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Long-Term Notes Payable (contd.)

Journal entries:

12/31/08 Cash 500,000

Mortgage N/P 500,000

6/30/09 Interest exp.* 30,000

Mortgage N/P 3,231

Cash 33,231

*Interest exp. = $500,000x 6% = $30,000

100

Page 101: Chapter 10

Presentation of Long-Term Liabilities on Balance Sheet Balance Sheet (partial)

Long term liabilities

Bonds payable, 8%, due 2015 $2,000,000

Less: Discount on bonds payable 90,000 $1,910,000 Mortgages note payable, 9% due

in 2023, secured by plant assets 700,000

Lease liability 800,000

Total long-term liabilities $3,410,000

101

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Current and Long-Term Liabilities 102

Advantages of Financing Operations with Bonds Versus Stock

Issuing StockIssuing Note orBonds Payable

Creates no liability orinterest expense. Doesnot increase debt /equityratio.

Does not dilute ownership.Results in higher earningsper share.

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Ratios

Debt to total assets ratio

= total debt/total assets Times interest earned ratio*

= income before income taxes and interest expense/interest expense

*Measured the company’s ability to meet interest payments when they are due.

103

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Current and Long-Term Liabilities 104

Other Long-Term Liabilities

a. Lease

b. Post-retirement benefits liabilities

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Current and Long-Term Liabilities 105

a. Lease

A lease is a contractual agreement in which the lessee agrees to make periodic payments to lessor in exchange for the usage of the assets (i.e., building, airplane, copiers, automobiles…).

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Current and Long-Term Liabilities 106

a. Lease

Operating Lease: treated as a rental agreements.

Capital Lease: treated as a purchase. (Thus, recognized leased assets as an assets and the lease obligation as a liability on the B/S.)

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Current and Long-Term Liabilities 107

a. Lease (contd.)

Off-balance-sheet financing: an acquisition of assets or services with debt that is not reported on the balance sheet (neither the assets nor the debt is reported).

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Current and Long-Term Liabilities 108

b. Post-retirement Benefits Liabilities

Based on SFAS No. 106, companies need to report the post retirement benefits (i.e., medical insurance provided to retirees) on an accrual basis starting 1993.

Therefore, companies started to report the liabilities for post retirement benefits (other than pensions) in 1993 on their B/S.

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Current and Long-Term Liabilities 109

b. Post-retirement Benefits Liabilities

For example, IBM reported 6,074 million post retirement benefits liabilities on 1993, about 25% of its stockholders’ equity.