Accounting principles 12th willey kieso chapter 15

Determining the Market Value of a BondIllustration: Assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in five years, with interest payable annually at y

Long-Term Liabilities

15

Learning Objectives

Describe the major characteristics of bonds.

Explain how to account for bond transactions.

Explain how to account for long-term notes payable.

Long-term liabilities are obligations that are expected to

be paid after one year.

Bonds are a form of interest-bearing notes payable.

 Sold in small denominations (usually $1,000 or multiples

of $1,000)

 Attract many investors

 Corporation issuing bonds is borrowing money

 Person who buys the bonds (the bondholder) is investing

Types of Bonds

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 terms set forth in legal document known as a bond

indenture

Bond certificate , typically a $1,000 face value.

Bonds

Issuing Procedures

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

Issued to obtain large amounts of long-term capital.

Investment company sells the bonds for the issuing

company.

Bonds

Issuing Procedures

Illustration 15-1

Bond certificate

Determining the Market Value of a Bond

Current market price (present value) is a function of the three factors:

1.dollar amounts to be received, 2.length of time until the amounts are received, and 3.market rate of interest

The market interest rate is the rate investors demand for

loaning funds.

Determining the Market Value of a Bond

Illustration: Assume that Acropolis Company on January 1, 2017,

issues $100,000 of 9% bonds, due in five years, with interest

payable annually at year-end The purchaser of the bonds would

receive the following two types of cash payments: (1) principal of

$100,000 to be paid at maturity, and (2) five $9,000 interest

payments ($100,000 x 9%) over the term of the bonds

Illustration 15-2

Determining the Market Value of a Bond

The current market price of a bond is equal to the present value of all the future cash payments promised by the bond

Illustration 15-2

State whether each of the following statements is true or false

_ 1 Mortgage bonds and sinking fund bonds are both

examples of secured bonds

_ 2 Unsecured bonds are also known as debenture

bonds

_ 3 The stated rate is the rate investors demand for

loaning funds

_ 4 The face value is the amount of principal the

issuing company must pay at the maturity date

_ 5 The market price of a bond is equal to its maturity

Corporation records bond transactions when it

 issues (sells),

 redeems (buys back) bonds, and

 when bondholders convert bonds into common stock

NOTE: If bondholders sell their bond investments to other investors,

the issuing company receives no further money on the transaction,

nor does the issuing company journalize the transaction.

Issue at Face Value, Discount, or Premium?

Bond Contractual

Interest Rate 10%

Illustration 15-4

Interest rates and bond prices

Accounting for Bond Transactions

The rate of interest investors demand for loaning funds to a

corporation is the:

Question

Accounting for Bond Transactions

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

Illustration: On January 1, 2017, Candlestick, Inc issues

$100,000, five-year, 10% bonds at 100 (100% of face value) The entry to record the sale is:

Bonds Payable 100,000

Issuing Bonds at Face Value

Illustration: On January 1, 2017, Candlestick, Inc issues

$100,000, five-year, 10% bonds at 100 (100% of face value) Assume that interest is payable annually on January 1 At

December 31, 2017, Candlestick recognizes interest expense incurred with the following entry Assume monthly accruals

have not been made.

Interest Payable 10,000

Issuing Bonds at Face Value

Illustration: On January 1, 2017, Candlestick, Inc issues

$100,000, five-year, 10% bonds at 100 (100% of face value) Assume that interest is payable annually on January 1

Candlestick records the payment on January 1, 2018, as

follows.

Cash 10,000

Issuing Bonds at Face Value

Illustration: On January 1, 2017,

Candlestick, Inc sells $100,000, five-year,

10% bonds for $98,000 (98% of face value)

Interest is payable annually January 1 The

entry to record the issuance is:

Bonds Payable 100,000

Issuing Bonds at a Discount

Sale of bonds below face value (discount) =

total cost of borrowing > interest paid

Reason: Borrower is required to pay the bond discount at the

maturity date Therefore, the bond discount is considered

to be a increase in the cost of borrowing.

Statement Presentation Illustration 15-5Statement presentation of

discount on bonds payable

Carrying value or book value

Issuing Bonds at a Discount

Total Cost of Borrowing

Issuing Bonds at a Discount

Illustration 15-8

Amortization of bond discount

Discount on Bonds Payable:

Question

Issuing Bonds at a Discount

Jan 1 Cash 102,000

Bonds Payable 100,000

Premium on Bonds Payable

Illustration: On January 1, 2017,

Candlestick, Inc sells $100,000, five-year,

10% bonds for $102,000 (102% of face

value) Interest is payable annually

January 1 The entry to record the issuance

is:

Issuing Bonds at a Premium

Sale of bonds above face value (premium) =

total cost of borrowing < interest paid

Reason: Borrower is not required to pay the bond premium

at the maturity date of the bonds Therefore, the bond

premium is considered to be a reduction in the cost of borrowing.

Statement Presentation Illustration 15-9Statement presentation of

discount on bonds payable

Issuing Bonds at a Premium

Total Cost of Borrowing

Issuing Bonds at a Premium

Illustration 15-12

Amortization of bond premium

Giant Corporation issues $200,000 of bonds for $189,000 (a)

Prepare the journal entry to record the issuance of the bonds, and

(b) show how the bonds would be reported on the balance sheet at the date of issuance

Jan 1 Bonds Payable 100,000

Cash 100,000

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:

REDEEMING BONDS AT MATURITY

When bonds are redeemed 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 any

remaining bond discount or plus any remaining bond premium at the

redemption date.

REDEEMING BONDS BEFORE MATURITY

When bonds are redeemed before maturity, the gain or loss

on redemption is the difference between the cash paid and

the:

Question

REDEEMING BONDS BEFORE MATURITY

Illustration: Assume Candlestick, Inc has sold its bonds at a

premium At the end of the fourth period, Candlestick retires

these bonds at 103 after paying the annual interest The

carrying value of the bonds at the redemption date is $100,400 Candlestick makes the following entry to record the redemption

at the end of the fourth interest period (January 1, 2021):

Cash

REDEEMING BONDS BEFORE MATURITY

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

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—

Common Stock 80,000

CONVERTING BONDS INTO COMMON STOCK

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

How About Some Green Bonds?

Unilever recently began producing popular frozen treats such as Magnums and Cornettos, funded by green bonds Green bonds are debt used to fund activities such as renewable- energy projects In Unilever’s case, the proceeds from the sale of green bonds are used to clean up the company’s manufacturing operations and cut waste (such as related to energy consumption)

The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green-bond proceeds These standardized disclosures provide transparency as to how these bonds are used and their effect

on overall profitability Investors are taking a strong interest in these bonds Investing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes The disclosures

of how companies are using the bond proceeds help investors to make better financial decisions

Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p C5.

People, Planet, and Profit Insight Unilever

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

Illustration: Porter Technology Inc issues a $500,000, 8%,

20-year mortgage note on December 31, 2017 The terms

provide for semiannual installment payments of $50,926 (not

including real estate taxes and insurance)

Long-Term Notes Payable

Illustration 15-13

Mortgage installment payment schedule

Dec 31 Cash 500,000

Mortgage Payable 500,000

Cash

Illustration: Porter Technology Inc issues a $500,000, 8%,

20-year mortgage note on December 31, 2017 The terms

provide for semiannual installment payments of $50,926 (not

including real estate taxes and insurance) Prepare the

entries to record the mortgage and first payment.

Long-Term Notes Payable

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

Long-Term Notes Payable

Cole Research issues a $250,000, 6%, 20-year mortgage note to

obtain needed financing for a new lab The terms call for annual

payments of $21,796 each Prepare the entries to record the

mortgage loan and the first payment

Solution

Mortgage Payable 250,000

Interest Expense ($250,000 x 6%) 15,000*

Cash

Presentation Illustration 15-14Balance sheet presentation

of long-term liabilities

Companies report the current maturities of long-term debt under

current liabilities if they are to be paid within one year or the

operating cycle, whichever is longer

Two ratios that provide information long-run solvency

and the ability to meet interest payments as they come

due are:

 Debt to Assets Ratio

 Times Interest Earned

Use of Ratios

Illustration: Kellogg Company reported 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 assets , the greater the

risk that the company may be unable to meet its maturing

obligations.

Illustration 15-15

Debt to assets ratio

Use of Ratios

Illustration: Kellogg Company reported 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

Times interest earned

Times interest earned indicates the company’s ability to meet interest payments as they come due.

Use of Ratios

Debt and Equity Financing

Illustration 15-17

Advantages of bond financing

over common stock

Illustration: Microsystems, Inc is considering two plans for financing the

construction of a new $5 million plant It is considering two alternatives for

raising an additional $5 million: Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share Plan B involves

issuing $5 million of 8% bonds at face value Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%.

Debt and Equity Financing

Illustration 15-18

A lease is a contractual arrangement between a lessor (owner

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

Illustration 15-19Lease Liabilities and Off-Balance-Sheet

Financing

Operating Lease Capital Lease

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)

Lease Liabilities

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

CAPITAL LEASES

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

CAPITAL LEASES

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

NO NO

Capital Lease?

CAPITAL LEASES

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

CAPITAL LEASES

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

CAPITAL LEASES