chapter 15-1. chapter 15-2 chapter 15 accounting principles, ninth edition long-term liabilities

Chapter 15-1

Chapter 15-2

Chapter 15

Accounting Principles, Ninth Edition

Long-Term Liabilities

Chapter 15-3

1. Explain why bonds are issued.

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

3. Describe the entries when bonds are redeemed or converted.

4. Describe the accounting for long-term notes payable.

5. Contrast the accounting for operating and capital leases.

6. Identify the methods for the presentation and analysis of long-term liabilities.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 15-4

Issuing bonds Issuing bonds at face valueat face value

Discount or Discount or premiumpremium

Issuing bonds Issuing bonds at a discountat a discount

Issuing bonds Issuing bonds at a premiumat a premium

Bonds BasicsBonds BasicsBonds BasicsBonds Basics Bond IssuesBond IssuesBond IssuesBond Issues Bond Bond RetirementsRetirements

Bond Bond RetirementsRetirements

Other Long-Other Long-Term Term

LiabilitiesLiabilities

Other Long-Other Long-Term Term

LiabilitiesLiabilities

Statement Statement Presentation Presentation and Analysisand Analysis

Statement Statement Presentation Presentation and Analysisand Analysis

Types of Types of bondsbonds

Issuing Issuing proceduresprocedures

TradingTrading

Market valueMarket value

Redeeming Redeeming bonds at bonds at maturitymaturity

Redeeming Redeeming bonds before bonds before maturitymaturity

Converting Converting bonds into bonds into common common stockstock

Long-term Long-term notes payablenotes payable

Lease Lease liabilitiesliabilities

PresentationPresentation

AnalysisAnalysis

Long-Term LiabilitiesLong-Term LiabilitiesLong-Term LiabilitiesLong-Term Liabilities

Chapter 15-5

Bonds are a form of interest-bearing notes payable.

Three advantages over common stock:

Bond BasicsBond BasicsBond BasicsBond Basics

SO 1 Explain why bonds are issued.SO 1 Explain why bonds are issued.

1. Stockholder control is not affected.

2. Tax savings result.

3. Earnings per share may be higher.

Chapter 15-6

Effects on earnings per share—stocks vs. bonds.



Illustration 15-2

Chapter 15-7

The 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.

QuestionQuestion



Chapter 15-8

Types of Bonds

Secured and Unsecured (debenture) bonds.

Term and Serial bonds.

Registered and Bearer (or coupon) bonds.

Convertible and Callable bonds.



Chapter 15-9

Issuing Procedures

Bond contract known as a bond indenture.

Represents a promise to pay:

(1) sum of money at designated maturity date, plus

(2) periodic interest at a contractual (stated) rate on the maturity amount (face value).

Paper certificate, typically a $1,000 face value.

Interest payments usually made semiannually.

Generally issued when the amount of capital needed is too large for one lender to supply.



Chapter 15-10



Issuer of Bonds

Issuer of Bonds

MaturityDate

MaturityDate

Illustration 15-3

Contractual Interest

Rate

Contractual Interest

Rate

Face or Par ValueFace or

Par Value

Chapter 15-11

Bond TradingBonds traded on national securities exchanges.

Newspapers and the financial press publish bond prices and trading activity daily.



Read as: Outstanding 5.125%, $1,000 bonds that mature in 2011. Currently yield a 5.747% return. On this day, $33,965,000 of these bonds were traded. Closing price was 96.595% of face value, or $965.95.

Chapter 15-12

Determining the Market Value of Bonds

Market value is a function of the three factors that determine present value:

1. the dollar amounts to be received,

2. the length of time until the amounts are received, and

3. the market rate of interest.



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

Chapter 15-13

6%

8%

10%

Premium

Face Value

Discount

Assume Contractual Rate of 8%Assume Contractual Rate of 8%

Accounting for Bond IssuesAccounting for Bond IssuesAccounting for Bond IssuesAccounting for Bond Issues

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

Bonds Sold AtMarket Interest

Chapter 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.

QuestionQuestion



expense.

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.

QuestionQuestion


Chapter 15-16

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is:

Issuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face Value


Jan. 1 Cash 100,000

Bonds payable 100,000

Chapter 15-17

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest ispayable semiannually on January 1 and July 1. Prepare the entry to record the payment of interest on July 1, 2010, assume no previous accrual.



July 1 Bond interest expense 5,000

Cash 5,000

Chapter 15-18

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest ispayable semiannually on January 1 and July 1. Prepare the entry to record the accrual of interest on December 31, 2010, assume no previous accrual.



Dec. 31 Bond interest expense 5,000

Bond interest payable 5,000

Chapter 15-19

Issuing Bonds at a DiscountIssuing Bonds at a DiscountIssuing Bonds at a DiscountIssuing Bonds at a Discount


Illustration: On January 1, 2010, 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

Chapter 15-20

Statement PresentationStatement Presentation



Illustration 15-6

Chapter 15-21



Total Cost of BorrowingTotal Cost of Borrowing

Illustration 15-7

Illustration 15-8


expense.

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.

QuestionQuestion



expense.

Illustration: On January 1, 2010, 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:Jan. 1 Cash 108,111


Premium on bond payable 8,111

Issuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a Premium

Chapter 15-24

Statement PresentationStatement Presentation


Issuing bonds at an amount different from face value is quite common. By the time a company prints the bond certificates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same.


Illustration 15-9


expense.

Total Cost of BorrowingTotal Cost of Borrowing

Illustration 15-10

Illustration 15-11


Chapter 15-26

Redeeming Bonds at Maturity

Accounting for Bond RetirementsAccounting for Bond RetirementsAccounting for Bond RetirementsAccounting for Bond Retirements

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

Chapter 15-27

Redeeming Bonds before Maturity

When a company retires bonds before maturity, it is necessary to:

1. eliminate the carrying value of the bonds at the redemption date;

2. record the cash paid; and

3. recognize the 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.



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

converted.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.

QuestionQuestion


Chapter 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, 2014):


Premium on bonds payable 1,623

Loss on redemption 1,377

Cash 103,000



Chapter 15-30

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.



Chapter 15-31

Illustration: Assume that 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 80,000



Chapter 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.

QuestionQuestion



Chapter 15-33

Long-Term Notes Payable

May be secured by a mortgage that pledges title to specific assets as security for a loan

Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of

1. interest on the unpaid balance of the loan and

2. a reduction of loan principal.

Companies initially record mortgage notes payable at face value.

Accounting for Other Long-Term Accounting for Other Long-Term LiabilitiesLiabilitiesAccounting for Other Long-Term Accounting for Other Long-Term LiabilitiesLiabilities

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

Chapter 15-34

Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2010. 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 15-12

Chapter 15-35



Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2010. 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 500,000Mortgage notes payable 500,000

Jun. 30 Interest expense 30,000Mortgage notes payable 3,231

Cash 33,231

Chapter 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.

QuestionQuestion



Chapter 15-37

Chapter 15-38

Lease Liabilities

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 15-13

Chapter 15-39

Operating LeaseOperating Lease Capital LeaseCapital Lease

Journal Entry:Journal Entry:

Rent expenseRent expense xxx xxx

CashCash xxx xxx

Journal Entry:Journal Entry:

Leased equipment xxxLeased equipment xxx

Lease liability xxxLease liability xxx

The issue of how to report leases is the case of The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the . Although technically legal title may not pass, the benefits from the use of the property do.benefits from the use of the property do.

Statement of Financial Accounting Standard No. 13, Statement of Financial Accounting Standard No. 13, “Accounting for Leases,” 1976“Accounting for Leases,” 1976

A lease that transfers substantially all of the benefits and risks A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only of property ownership should be capitalized (only noncancellable leases may be capitalized).noncancellable leases may be capitalized).



Chapter 15-40

To capitalize a lease, one or more of four criteria must be met:

1. Transfers ownership to the lessee.

2. Contains a bargain purchase option.

3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.

4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.



Chapter 15-41

Exercise: 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, whichis 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.



Chapter 15-42

Exercise: (a) What type of lease is this? Explain.

Capitalization Criteria:Capitalization Criteria:

1.1. Transfer of ownershipTransfer of ownership

2.2. Bargain purchase optionBargain purchase option

3.3. Lease term => 75% of Lease term => 75% of economic life of leased economic life of leased propertyproperty

4.4. Present value of Present value of minimum lease payments minimum lease payments => 90% of FMV of => 90% of FMV of propertyproperty

NONO

NONO

Lease term

4 yrs.Economic life

5 yrs. YES

80%

YES - PV and FMV are the same.

Capital Lease?



Chapter 15-43

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



The portion of the lease liability expected to be paid in The portion of the lease liability expected to be paid in the next year is a current liability. The remainder is the next year is a current liability. The remainder is classified as a long-term liability.classified as a long-term liability.

Leased asset - equipment 190,000

Lease liability 190,000

Chapter 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.

QuestionQuestion



Chapter 15-45

Presentation

SO 6 Identify the methods for the presentation and analysis of long-term liabilities.

Statement Analysis and PresentationStatement Analysis and PresentationStatement Analysis and PresentationStatement Analysis and Presentation

Illustration 15-14

Chapter 15-46

Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Total debt

Total assets

Debt to total

assets

=

The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

1.1.



Chapter 15-47

Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Income before income taxes and interest expense

Interest expense

Times interest earned

=

Indicates the company’s ability to meet interest payments as they come due.

2.2.



Chapter 15-48

Chapter 15-49

To illustrate present value concepts, 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,

divide the future amount by 1 plus the interest rate ($1,000/1.10 = $909.09 OR

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.SO 7 Compute the market price of a bond.

Present Value Concepts Related to Bond Present Value Concepts Related to Bond PricingPricingPresent Value Concepts Related to Bond Present Value Concepts Related to Bond PricingPricing

Appendix 15APresent Value of Face

Value

Chapter 15-50


divide the future amount by 1 plus the interest rate ($1,000/1.10 = $909.09.

Present Value Concepts Related to Bond Present Value Concepts Related to Bond PricingPricingPresent Value Concepts Related to Bond Present Value Concepts Related to Bond PricingPricingPresent Value of Face Value

Illustration 15A-1


Chapter 15-51


use a Present Value of 1 table. ($1,000 X .90909) = $909.09 (10% per period, one period from now).



Chapter 15-52

The future amount ($1,000), the interest rate (10%), and the number of periods (1) are known



Illustration 15A-2

Chapter 15-53

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

Chapter 15-54

To compute the answer using a Present Value of 1 table. ($1,000 X .82645) = $826.45 (10% per period, two periods from now).



Chapter 15-55

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 Concepts Related to Bond Present Value Concepts Related to Bond PricingPricingPresent Value Concepts Related to Bond Present Value Concepts Related to Bond PricingPricingPresent Value of Interest Payments (Annuities)

Chapter 15-56

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



Illustration 15A-5

Chapter 15-57




Illustration 15A-6

Chapter 15-58




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

Chapter 15-59 SO 7 Compute the market price of a bond.SO 7 Compute the market price of a bond.


Computing the Present Value of a Bond

The selling price of a bond is equal to the sum of:

1) The present value of the face value of the bond discounted at the investor’s required rate of return

PLUS

2) The present value of the periodic interest payments discounted at the investor’s required rate of return

Chapter 15-60

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



Chapter 15-61


Illustration 15A-9



Contractual Rate = Discount Rate Issued at Face Value

Chapter 15-62


Illustration 15A-10



Contractual Rate < Discount Rate Issued at a Discount

Chapter 15-63


Illustration 15A-11



Contractual Rate > Discount Rate Issued at a Premium

Chapter 15-64

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

1. Compute the bond interest expense.

2. Compute the bond interest paid or accrued.

3. Compute the amortization amount.

Effective-Interest Method of Bond Effective-Interest Method of Bond AmortizationAmortizationEffective-Interest Method of Bond Effective-Interest Method of Bond AmortizationAmortization

Appendix 15B

Chapter 15-65

Assume 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

Amortizing Bond Discount



Chapter 15-66

Assume 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.

Journal entry on July 1, 2010, 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


Chapter 15-67

Illustration 15B-4



Amortizing Bond PremiumAssume Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2010, for $108,111, with interest payable each July 1 and January 1. This results in a premium of $8,111.

Chapter 15-68



Interest Expense 4,324

Cash 5,000

Premium on Bonds Payable 676

July 1

Amortizing Bond PremiumAssume Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2010, for $108,111, with interest payable each July 1 and January 1. This results in a premium of $8,111.

Journal entry on July 1, 2010, to record the interest payment and amortization of premium is as follows:

Chapter 15-69

Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2010, 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).

Illustration 15C-2


Straight-Line AmortizationStraight-Line AmortizationStraight-Line AmortizationStraight-Line Amortization

SO 9 Apply the straight-line method of SO 9 Apply the straight-line method of amortizing amortizing bond discount and bond bond discount and bond premium.premium.

Appendix 15C

Chapter 15-70

Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2010, 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, 2010, to record the interest payment and amortization of discount is as follows: Interest Expense 5,736

Cash 5,000

Discount on Bonds Payable 736

July 1


Straight-Line AmortizationStraight-Line AmortizationStraight-Line AmortizationStraight-Line Amortization

SO 9 Apply the straight-line method of SO 9 Apply the straight-line method of amortizing amortizing bond discount and bond bond discount and bond premium.premium.

Chapter 15-71

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chapter 15-1. chapter 15-2 chapter 15 accounting principles, ninth edition long-term liabilities

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