Accounting principles 10e by kieso chapter 15

Maturity DateMaturity Date Illustration 15-3 Contractual Interest Rate Contractual Interest Rate Bond Basics Issuer of Bonds Issuer of Bonds... The entry to record the sale is: Issuing B

CHAPTER 15

Long-Term Liabilities

Preview of CHAPTER 15

Bonds are a form of interest-bearing notes payable.

1 Stockholder control is not affected.

2 Tax savings result.

3 Earnings per share may be higher.

Bond Basics

Effects on earnings per share—stocks vs bonds.

Illustration 15-2

Bond Basics

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

Question

Bond Basics

 Secured and Unsecured (debenture) bonds.

 Term and Serial bonds

 Registered and Bearer (or coupon) bonds

 Convertible and Callable bonds

Bond Basics

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 contract known as a bond indenture

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

Bond Basics

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

 Generally issued when the amount of capital needed is

Bond Basics

Issuing Procedures

Maturity Date

Maturity Date Illustration 15-3

Contractual Interest Rate

Contractual Interest Rate

Bond Basics

Issuer of Bonds Issuer of Bonds

Determining the Market Value of Bonds

Bond Basics

Market value is a function of the three factors that determine

present value:

1 dollar amounts to be received,

2 length of time until the amounts are received, and

3 market rate of interest

Corporation records bond transactions when it

 issues (sells),

 retires (buys back) bonds and

 when bondholders convert bonds into common stock

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

the issuing firm receives no further money on the transaction, nor

does the issuing corporation journalize the transaction.

Accounting for Bond Issues

Issue at Par, Discount, or Premium?

Accounting for Bond Issues

Illustration 15-4

Bond Contractual

Interest Rate

of 10%

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.

Accounting for Bond Issues

Question

Karson Inc issues 10-year bonds with a maturity value of

$200,000 If the bonds are issued at a premium, this indicates

c the contractual interest rate and the market interest rate

are the same

Question

Accounting for Bond Issues

Illustration: On January 1, 2012, Candlestick Corporation

issues $100,000, five-year, 10% bonds at 100 (100% of face

value) The entry to record the sale is:

Issuing Bonds at Face Value

Accounting for Bond Issues

Illustration: On January 1, 2012, Candlestick Corporation

issues $100,000, five-year, 10% bonds at 100 (100% of face

value) Assume that interest is payable semiannually on

January 1 and July 1 Prepare the entry to record the payment

of interest on July 1, 2012, assume no previous accrual

Issuing Bonds at Face Value

Illustration: On January 1, 2012, Candlestick Corporation

issues $100,000, five-year, 10% bonds at 100 (100% of face

value) Assume that interest is payable semiannually on

January 1 and July 1 Prepare the entry to record the accrual

of interest on December 31, 2012, assume no previous accrual

Dec 31 Interest expense 5,000

Issuing Bonds at Face Value

Illustration: On January 1, 2012, 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:

Discount on bonds payable 7,361

Accounting for Bond Issues

Issuing Bonds at a Discount

Sale of bonds below face value causes the total cost of borrowing

to be more than the bond interest paid

The reason: Borrower is required to pay the bond discount at the

maturity date Thus, the bond discount is considered to be a

increase in the cost of borrowing.

Statement Presentation

Illustration 15-5

Issuing Bonds at a Discount

Carrying value or book value

Total Cost of Borrowing

Illustration 15-6

Illustration 15-7

Issuing Bonds at a Discount

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

Issuing Bonds at a Discount

Question

Jan 1 Cash 108,111

Illustration: On January 1, 2012, 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:

Accounting for Bond Issues

Issuing Bonds at a Premium

Statement Presentation

Sale of bonds above face value causes the total cost of borrowing

to be less than the bond interest paid

The reason: The borrower is not required to pay the bond premium at

the maturity date of the bonds Thus, the bond premium is

considered to be a reduction in the cost of borrowing.

Illustration 15-8

Issuing Bonds at a Premium

Total Cost of Borrowing

Illustration 15-9

Illustration 15-10

Issuing Bonds at a Premium

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:

Accounting for Bond Retirements

Redeeming Bonds at Maturity

When bonds are retired 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

Accounting for Bond Retirements

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:

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

Accounting for Bond Retirements

Question

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,

2016):

Accounting for Bond Retirements

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

Accounting for Bond Retirements

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:

Paid-in capital in excess of par value 80,000

Accounting for Bond Retirements

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

May be secured by a mortgage that pledges title to specific

assets as security for a loan.

Typically, terms require borrower to make installment payments

over the term of the loan Each payment consists of

 interest on the unpaid balance of the loan and

 a reduction of loan principal.

Accounting for Other Long-Term Liabilities

Long-Term Notes Payable

Illustration: Porter Technology Inc issues a $500,000, 12%,

20-year mortgage note on December 31, 2012 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 15-11

Accounting for Other Long-Term Liabilities

Dec 31 Cash 500,000

Accounting for Other Long-Term Liabilities

Illustration: Porter Technology Inc issues a $500,000, 12%,

20-year mortgage note on December 31, 2012 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.

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

Accounting for Other Long-Term Liabilities

Question

A lease is a contractual arrangement between a lessor (owner

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

Illustration 15-12

Accounting for Other Long-Term Liabilities

Lease Liabilities

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

Accounting for Other Long-Term 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

Accounting for Other Long-Term Liabilities

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

Accounting for Other Long-Term Liabilities

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

NO NO

Capital Lease?

Accounting for Other Long-Term Liabilities

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

Accounting for Other Long-Term Liabilities

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

Accounting for Other Long-Term Liabilities

Question

Illustration 15-13

Statement Presentation and Analysis

Presentation

Two ratios that provide information about debt-paying

ability and long-run solvency are:

 Debt to Total Assets Ratio

 Times Interest Earned Ratio

Statement Presentation and Analysis

Analysis

Illustration: Kellogg had 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.

Statement Presentation and Analysis

Analysis

Illustration: Kellogg had 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.

Times interest earned indicates the company’s ability to meet

interest payments as they come due.

Statement Presentation and Analysis

Analysis

Illustration: 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,

1 divide the future amount by 1 plus the interest rate

($1,000/1.10 = $909.09 OR

2 use a Present Value of 1 table ($1,000 X 90909) = $909.09

(10% per period, one period from now).

APPENDIX 15A Concepts Related Present Value

to Bond Pricing

Present Value of Face Value

To compute the answer,

1 divide the future amount by 1 plus the interest rate

($1,000/1.10 = $909.09

Illustration 15A-1

Present Value of Face Value

Present Value of Face Value

To compute the answer,

2 use a Present Value of 1 table ($1,000 X 90909) =

$909.09 (10% per period, one period from now)

The future amount ($1,000), the interest rate (10%), and the

number of periods (1) are known

Illustration 15A-2

Present Value of Face Value

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

Present Value of Face Value

To compute the answer using a Present Value of 1 table

($1,000 X 82645) = $826.45 (10% per period, two periods

from now)

Present Value of Face Value

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 of Interest Payments (Annuities)

Assume that you will receive $1,000 cash annually for three

years and the interest rate is 10%

Illustration 15A-5

Present Value of Interest Payments (Annuities)

Illustration 15A-6

Present Value of Interest Payments (Annuities)

Assume that you will receive $1,000 cash annually for three

years and the interest rate is 10%

Present Value of Interest Payments (Annuities)

Assume that you will receive $1,000 cash annually for three

years and the interest rate is 10%

Selling price of a bond is equal to the sum of:

 Present value of the face value of the bond discounted

at the investor’s required rate of returnPLUS

 Present value of the periodic interest payments

discounted at the investor’s required rate of return

Computing the Present Value of a Bond

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

Computing the Present Value of a Bond

Illustration 15A-9

Computing the Present Value of a Bond

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-10

Computing the Present Value of a Bond

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