Accounting principles 11e kieso kimmel chapter 015

 Board of directors must stipulate number of bonds to be authorized, total face value, and contractual interest rate.. Maturity DateMaturity Date Contractual Interest Rate Contractual

Prepared by Coby Harmon University of California, Santa Barbara

Westmont College

Learning Objectives

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 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

Long-Term Liabilities

Preview of Chapter 15

Accounting Principles Eleventh Edition

Bonds are a form of interest-bearing notes payable.

Three advantages over common stock:

1 Stockholder control is not affected.

2 Tax savings result.

3 Return on common stockholders’ equity may be higher.

Bond Basics

Helpful Hint Besides

corporations, governmental agencies and universities also issue bonds to raise capital.

Helpful Hint Besides corporations, governmental agencies and universities also issue bonds to raise capital.

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

too large for one lender to supply.

Bond Basics

Issuing Procedures

Maturity Date

Maturity Date

Contractual Interest Rate

Contractual Interest Rate

Bond Basics

Issuer of Bonds

Issuer of Bonds

Illustration 15-3 Bond certificate

Determining the Market Value of a Bond

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

market rate of the bond

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 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

Accounting for Bond Issues

Question

Illustration: On January 1, 2014, Candlestick, Inc 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, 2014, Candlestick, Inc 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, 2014, assume no previous accrual

July 1 Interest Expense 5,000

Issuing Bonds at Face Value

Illustration: On January 1, 2014, Candlestick, Inc 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, 2014, assume no previous accrual

Dec 31 Interest Expense 5,000

Issuing Bonds at Face Value

Illustration: On January 1, 2014, 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

Premium on Bonds Payable 8,111

Illustration: On January 1, 2014, 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

Jan 1 Bonds Payable 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:

Accounting for Bond Redemptions

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

unamortized bond discount or plus unamortized bond premium at the

redemption date.

Accounting for Bond Redemptions

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 Redemptions

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, 2018):

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 Redemptions

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 80,000

Accounting for Bond Redemptions

July 1

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.

Accounting for Bond Redemptions

Question

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

Companies initially record mortgage notes payable at face value

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, 2014 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, 2014 The terms provide for semiannual installment payments of $33,231 (not including real

estate taxes and insurance) Prepare the entries to record the

mortgage and first payment

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

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 risks

of property ownership should be capitalized (only

noncancellable leases may be capitalized)

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

b Prepare the journal entry to record the lease

Accounting for Other Long-Term Liabilities

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

NO NO

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

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

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

The higher the percentage of debt to total assets, the greater the

Statement Presentation and Analysis

Analysis

Times interest earned indicates the company’s ability to meet

Statement Presentation and 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

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)

Present Value of a Single Amount

APPENDIX 15A Present Value Concepts Related to Bond Pricing

To compute the answer,

1 divide the future amount by 1 plus the interest rate

($1,000 ÷ 1.10 = $909.09.

Illustration 15A-1

APPENDIX 15A Present Value of a Single Amount

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).

APPENDIX 15A Present Value of a Single Amount

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

number of periods (1) are known

Illustration 15A-2

APPENDIX 15A Present Value of a Single Amount

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].

APPENDIX 15A Present Value of a Single Amount

Illustration 15A-3

To compute the answer using a Present Value of 1 table

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

from now).

APPENDIX 15A Present Value of a Single Amount

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

APPENDIX 15A Present Value of Interest Payments (Annuities)