Accounting principles 7th kieso kimel chapter 16

Bond BasicsSTUDY OBJECTIVE 1 • Bonds – interest-bearing notes payable – issued by corporations, universities, and governmental agencies – like common stock, can be sold in small denom

Chapter 16

LONG-TERM LIABILITIES

Prepared by Naomi Karolinski Monroe Community College

and

Accounting Principles, 7th Edition

Weygandt • Kieso • Kimmel

CHAPTER 16

LONG-TERM LIABILITIES

After studying this chapter, you should be able to:

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

6 Identify the methods for the presentation

and analysis of long-term liabilities.

Long-Term Liabilities

• Obligations that are expected to be

paid after one year

• Include bonds, long-term notes, and

lease obligations

Bond Basics

STUDY OBJECTIVE 1

• Bonds

– interest-bearing notes payable

– issued by corporations, universities, and

governmental agencies

– like common stock, can be sold in small

denominations (usually a thousand dollars)

– attract many investors

• To obtain large amounts of long-term capital,

corporate management usually must decide whether to issue bonds or to use equity

financing (common stock).

Why Issue Bonds?

Long-term financing, bonds, offer the

following advantages over common

Disadvantages of Bonds

1) Interest must be paid on a periodic basis

2) Principal (face value) must be repaid at maturity

1) Secured bonds

Specific assets of the issuer pledged as

collateral for the bonds( a mortgage bond

is secured by real estate)

2) Unsecured bonds

Issued against the general credit of the

borrower; they are also called debenture

bonds

Types of Bonds Secured and Unsecured

Types of Bonds:

Registered and Bearer

5)Registered bonds

interest payments made by check to

bondholders of record

6)Bearer or coupon bonds

in coupons to receive interest payments

Registered Pay to: Joe Smith

Types of Bonds Convertible and Callable

• Convertible

– convert the bonds

into common stock at

holder’s option

• Callable

– subject to call and

retirement at a stated

dollar amount prior to

maturity at the option

of the issuer

Authorizing a Bond Issue

• State laws grant corporations the power to

issue bonds

– approval by both the Board of Directors and

stockholders is usually required

• Board of Directors stipulate the number of

bonds to be authorized, total face value, and contractual interest rate

Issuing Procedures

• Face value

– amount of principal the issuer must pay at the

maturity date

• Contractual interest rate , or stated rate

– rate used to determine the amount of cash

interest the borrower pays and the investor

– Printed document providing information such as

name of issuer and maturity date

Bond Certificate

Bond Trading

• Corporate bonds

– traded on national securities exchanges

– bondholders have the opportunity to convert their holdings

into cash by selling the bonds at the current market price

• Bond prices are quoted as a percentage of the face

value of the bond (usually $1,000)

• Transactions between a bondholder and other

investors are not journalized by the issuing

corporation

• A corporation only makes journal entries when it

issues or buys back bonds, and when bondholders convert bonds into common stock.

Determining the Market Value of Bonds

The market value ( present value )

of a bond is determined by:

1) the dollar amounts to be received

2) the length of time until the amounts are received

3) the market rate of interest, which is the rate

investors demand for loaning funds

• The process of finding the present value is

referred to as discounting the future amounts.

Accounting for Bond

Issues Issuing Bonds at Face

Value

STUDY OBJECTIVE 2

1,000,000

Bonds may be issued at face value, below face value (at a discount),

or above face value (at a premium) They also are sometimes

issued between interest dates Assume that Devor Corporation

issues 1,000, 10-year, 9% $1,000 bonds dated January 1, 2005, at 100 (100% of face value) The entry to record the sale is:

Bonds payable are reported in the long-term liability section

of the balance sheet because the maturity date is more than

one year away.

Accounting for Bond

Issues Issuing Bonds at Face

Value

45,000

45,000

Assuming that interest is payable semiannually on January

1 and July 1 on the bonds, interest of $45,000 ($1,000,000 x 9% x 6/12)must be paid on July 1, 2005 The entry for the payment is:

Accounting for Bond

Issues Issuing Bonds at Face

Value

45,000

45,000

At December 31, an adjusting entry is required to recognize

the $45,000 of interest expense incurred since July 1.

The entry is:

Bond interest payable is classified as a current liability, because it is

scheduled for payment within the next year When interest is paid on

January 1, 2006, Bond Interest Payable is debited, and Cash is credited for

$45,000 in order to eliminate the liability.

Interest Rates and Bond

Accounting for Bond Issues

Discount or Premium on

Bonds

value.

• Market (effective) rate of interest is higher

than the contractual (stated) rate

– the bonds will sell at less than face value, or at a discount

• Market rate of interest is less than the

contractual rate

– the bonds will sell above face value, or at a

premium

Issuing Bonds at a Discount

Assume that on January 1, 2005, Candlestick, Inc sells

$100,000, 5-year, 10% bonds for $92,639 (92.639% of face value) with interest payable on July 1 and January 1

The entry to record the issuance is:

The $92,639 represents the carrying (or book) value

of the bonds On the date of issue this amount

equals the market price of the bonds.

Statement Presentation of Discount on Bonds Payable

Although Discount on Bonds Payable has a debit balance,

it is NOT an asset Rather, it is a contra account, which

illustrated below:

Total Cost of Borrowing - Bonds Issued at Discount

• The difference between the issuance price and face

value of the bonds-the discount-is an additional

cost of borrowing that should be recorded as bond interest expense over the life of the bonds.

• The total cost of borrowing, $92,639 for Candlestick,

Inc., is $57,361, as computed as follows:

Alternative Computation of Total Cost of Borrowing - Bonds Issued at

Bonds Issued at a Discount

Issuing Bonds at a

Premium

We now assume the Candlestick, Inc bonds described in

the previous slides are sold for $108,111 (108.111% of face

value) rather than for $ 92,639.

108,111 100,000 8,111

Statement Presentation

of Bond Premium

Premium on bonds payable is added to

bonds payable on the balance sheet,

as shown below:

The sale of bonds above face value causes the total

cost of borrowing to be less than the bond interest paid The premium is considered to be a reduction in the cost

of borrowing that should be credited to Bond Interest

Expense over the life of the bonds.

Total Cost of Borrowing - Bonds Issued at a Premium

Semiannual Interest Payments

($100,000*10%*.5=$5,000; $5,000*10) $50,000 Less: Bond Premium ($108,111-$100,000) $8,111

Bonds Issued at a Premium

Alternative Computation of Total Cost of Borrowing - Bonds

Bonds Issued at a Premium

Redeeming Bonds at Maturity

STUDY OBJECTIVE 3

1,000,000

1,000,000

Regardless of the issue price of bonds, the book value

of the bonds at maturity will equal their face value.

Assuming that the interest for the last interest period

is paid and recorded separately, the entry to record the redemption of the Candlestick bonds at maturity is:

Bond Retirements

• Company decides to reduce interest

cost and remove debt from its balance sheet.

1) Eliminate the carrying value of the bonds at the redemption date.

2) Record the cash paid.

3) Recognize the gain or loss on

redemption

Redeeming Bonds Before

Maturity

Assume that at the end of the eighth period, Candlestick, Inc retires its bonds at 103 after paying the semiannual interest The carrying value of the bonds at the redemption date is

$101,623 The entry to record the redemption at the end

of the eighth interest period (January 1, 2009) is:

100,000

1,623 1,377 103,000

The term used for bonds that are unsecured is:

The term used for bonds that are unsecured is:

a callable bonds

b indenture bonds

c debenture bonds

d bearer bonds

Converting Bonds into

Common Stock

100,000

20,000 80,000

In recording the conversion of bonds into common stock the current market prices of the bonds and the stock are ignored Instead, the carrying value of the bonds is transferred to

paid-in capital accounts No gain or loss is recognized.

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 The entry to record the conversion is:

Other Long-Term Liabilities

Study Objective 4

• Long-term notes payable

– similar to short-term interest-bearing notes payable except

that the term of the note exceeds one year.

• Mortgage notes payable

– long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan

– are widely used by individuals to purchase homes and to

acquire plant assets by many small and some large

companies

– recorded initially at face value

– subsequent entries are required for each installment

payment

Mortgage Installment

Payment Schedule

12%, 20-year mortgage note on December 31, 2005, to obtain needed financing for the construction of a new research laboratory The

installment payment schedule for the first year is shown below:

Issue date $500,000

1 $33,231 $30,000 $3,231 496,769

2 $33,231 29,806 3,425 493,344

Long-term Notes Payable

Entries

The entries to record the mortgage loan and first

installment payment (per schedule on previous slide)

are as follows:

500,000

500,000 30,000

3,231

– lessor continues to own the property

– lease (or rental) payments are recorded as

an expense by the lessee and as revenue

by the lessor

Car rental

is an example

of an operating lease

Car rental

is an example

of an operating lease

Capital Leases

• The present value of the cash payments

for the lease are capitalized and recorded

as an asset.

• Capital lease is in substance an

installment purchase by the lessee.

Capital Leases

• Lessee records the lease as an asset (a capital

lease) if any one of the following conditions

exist:

a) Lease transfers ownership of the property to

the lessee.

b) Lease contains a bargain purchase option.

c) Lease term is equal to 75% or more of the

economic life of the leased property.

d) Present value of the lease payments equals or exceeds 90% of the fair market value of the

leased property.

Capital Lease Entries

The renting of an apartment is an example

The renting of an apartment is an example

Presentation and Analysis

of Long-Term Liabilities

STUDY OBJECTIVE 6

Long-term debt

– reported in the balance sheet or in schedules in

the notes accompanying the statements

– current maturities of long-term debt

• reported under current liabilities if they are to be paid from

current assets

– reported in a separate section of the balance

sheet immediately following current liabilities

The long-term liabilities for

LAX Corporation are shown below:

Balance Sheet Presentation of Long-term

Liabilities

Debt to Total Assets

The debt to total assets ratio measures the percentage

of total assets provided by creditors, indicating the

degree of leverage utilized It is calculated by dividing total debt by total assets Johnson & Johnson’s 2005 annual reported total debt of $17,859 million and total assets of $40,566 million Their debt to total assets ratio

is calculated below:

The debt to total assets ratio measures the percentage

of total assets provided by creditors, indicating the

degree of leverage utilized It is calculated by dividing

total debt by total assets Johnson & Johnson’s 2005 annual reported total debt of $17,859 million and total assets of $40,566 million Their debt to total assets ratio

is calculated below:

Times Interest Earned

Ratio

TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE EARNED =

—————————————————————————————

The times interest earned ratio indicates the company’s ability

to meet interest payments as they come due It is computed

by dividing income before income taxes and interest expense

by interest expense Johnson & Johnson’s annual report

disclosed interest expense $160 million, income taxes of

$2,694 , and net income of $6,597 million The times interest

earned ratio is computed below:

The times interest earned ratio indicates the company’s ability

to meet interest payments as they come due It is computed

by dividing income before income taxes and interest expense

by interest expense Johnson & Johnson’s annual report

disclosed interest expense $160 million, income taxes of

$2,694 , and net income of $6,597 million The times interest

earned ratio is computed below:

Appendix 16A Present Value

Concepts Related to Bond Pricing

Present Value – One Period Discount

Present Value – Two Period Discount

Present Value of Face Value

$10,000,000 X PV of 1 due in 3 years at 9% =

$10,000,000 X 77218 (Table 16A-1) $7,721,800 Amount to be received from winning state

You have just won the state lottery! Are you better off receiving

$10,000,000 three years from now or receiving a check for

$7,000,000 today if the appropriate discount rate is 9%?

Present Value of Interest

Present Value of Interest

Present Value of a Bond

Amortization

• An alternative to straight-line amortization

• Both methods result in the same total

amount of interest expense over the term of the bonds.

• If materially different

– the effective-interest method is required

under GAAP

Computation of Amortization -Effective-

Interest Method

• Bond interest expense

– computed by multiplying the carrying value of the bonds at the

beginning of the interest period by the effective-interest rate

• Bond discount or premium amortization

– computed by determining the difference between the bond interest

expense and the bond interest paid

(1) Bond Interest Expense

of Bonds Rate

x

Amortization Amount

Candlestick Inc issues $100,000 of 10%, 5-year bonds on January 1, 2005, with interest payable each July 1 and January 1 The bonds will sell for $92,639

with an effective interest rate of 12%; Therefore, the bond discount is $7,361 ($100,000 - $92,639) The schedule below facilitates recording of interest

expense and discount amortization.

Illustration 16B-3

Bond Discount Amortization Schedule

Issue date $7,361 $92,639

NOTE: TABLE WILL CONTINUE FOR 10 SEMIANNUAL PERIODS

$108,111 with an effective interest rate of 8%; therefore, the bond premium

is $8,111 ($108,111-$100,000) The schedule below facilitates recording of interest expense and premium amortization.

Candlestick Inc issues $100,000 of 10%, 5-year bonds on January 1, 2005, with interest payable each July 1 and January 1 The bonds will sell for

$108,111 with an effective interest rate of 8%; therefore, the bond premium

is $8,111 ($108,111-$100,000) The schedule below facilitates recording of interest expense and premium amortization.

NOTE: TABLE WILL CONTINUE FOR 10 SEMIANNUAL PERIODS