Accounting for Long-Term Liabilities Chapter 10 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Wild, Shaw, and Chiappetta Financial & Managerial Accounting 6th Edition Wild, Shaw, and Chiappetta Financial & Managerial Accounting 6th Edition

10-A1:Bond Financing 2

Bond Interest Payments Corporation Investors Bond Issue Date Bond Interest Payments Interest Payment = Bond Par Value × Stated Interest Rate x Time Bond Financing Transactions during the bond life A1 3

Bond Financing Bonds do not affect owner control. Interest on bonds is tax deductible. Bonds can increase return on equity. Advantages Bonds require payment of both periodic interest and par value at maturity. Bonds can decrease return on equity. Disadvantages A1 4

Bond Trading A1 Bonds are securities that can be purchased or sold in the securities markets. They have a market value which is expressed as a percent of their par value. The closing price indicates that the IBM stock is being sold at % of face value. 5

Bond Issuing Procedures A1 6

10-P1:Issuing Bonds at Par 7

Issuing Bonds at Par On Jan. 1, 2015, a company issued the following bonds: Par Value: $800,000 Stated Interest Rate: 9% Interest Dates: 6/30 and 12/31 Maturity Date = Dec. 31, 2034 (20 years) P1 8

$800,000 × 9% × ½ year = $36,000 Issuing Bonds at Par On June 30, 2015, the issuer of the bond pays the first semiannual interest payment of $36,000. P1 This entry is made every six months until the bonds mature. 9

Issuing Bonds at Par On December 31, 2034, the bonds mature and the issuer of the bond pays face value of $800,000 to the bondholders. P1 10

Bond Discount or Premium P1 11

10-P2:Issuing Bonds at a Discount 12

Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) Issuing Bonds at a Discount } } Bond will sell at a discount. P2 13

On Dec. 31, 2015, Fila should record the bond issue. Issuing Bonds at a Discount Par value $ 100,000 Cash proceeds 96,454* Discount $ 3,546 *$100,000 x % Contra-Liability Account Contra-Liability Account P2 14

Maturity Value Carrying Value Issuing Bonds at a Discount P2 15

$3,546 ÷ 4 periods = $887 (rounded) $100,000 × 8% × ½ = $4,000 $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 8% × ½ = $4,000 Fila will make the following entry every six months to record the cash interest payment and the amortization of the discount. Amortizing a Bond Discount P2 16

Amortizing a Bond Discount P2 These two columns always sum to par value for a discount bond. 17

NEED-TO-KNOW Semiannual Period-EndCarrying Value (0)12/31/20X1$248$6,752 (1)06/30/20X21866,814 (2)12/31/20X21246,876 (3)06/30/20X3626,938 (4)12/31/20X30$7,000 Change in Carrying Value $248 / 4 semiannual periods = $62 per period 12/31/20X124812/31/20X17,000 06/30/20X262 12/31/20X262 06/30/20X362 12/31/20X362 12/31/20X30 7,000 A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the discount. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20X1; (c ) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20X3. Discount on Bonds PayableBonds Payable Unamortized Discount << $7,000 x.9646 = $6,752 P1/P2 18

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. DebitCredit 12/31/20X1 Cash($7,000 x.9646)6,752 Discount on Bonds Payable248 Bonds Payable7,000 General Journal 12/31/20X124812/31/20X17,000 06/30/20X262 12/31/20X262 06/30/20X362 12/31/20X362 12/31/20X30 7,000 Discount on Bonds PayableBonds Payable P1/P2 19

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6, /31/20X124812/31/20X17,000 06/30/20X262 12/31/20X262 06/30/20X362 12/31/20X362 12/31/20X30 7,000 Discount on Bonds PayableBonds Payable DebitCredit 06/30/20X2 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 12/31/20X2 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 06/30/20X3 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 12/31/20X3 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 General Journal P1/P2 20

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. DebitCredit 06/30/20X2 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 12/31/20X2 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 06/30/20X3 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 12/31/20X3 Bond Interest Expense($280 + $62)342 Discount on Bonds Payable62 Cash($7,000 x 8% / 2)280 General Journal Interest expense = Amount repaid minus amount borrowed 4 payments of $280$1,120 1 payment of $7,0007,000 Total repaid8,120 Borrowed6,752 Total bond interest expense$1,368÷ 4 = $342 P1/P2 21

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6, /31/20X124812/31/20X17,000 06/30/20X262 12/31/20X262 06/30/20X362 12/31/20X362 12/31/20X30 7,000 Discount on Bonds PayableBonds Payable DebitCredit 12/31/20X3 Bonds Payable7,000 Cash7,000 General Journal P1/P2 22

10-P3:Issuing Bonds at a Premium 23

Adidas issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 12% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) Adidas issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 12% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) Issuing Bonds at a Premium } } Bond will sell at a premium. P3 24

Issuing Bonds at a Premium Par value $ 100,000 Cash proceeds 103,546* Premium $ 3,546 *$100,000 x % Adjunct-Liability Account Adjunct-Liability Account On Dec. 31, 2013, Adidas will record the bond issue as: P3 25

Issuing Bonds at a Premium Maturity Value Carrying Value P3 26

Amortizing a Bond Premium $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 12% × ½ = $6,000 $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 12% × ½ = $6,000 Adidas will make the following entry every six months to record the cash interest payment and the amortization of the discount. P3 27

Amortizing a Bond Premium P3 28

NEED-TO-KNOW Semiannual Period-EndCarrying Value (0)12/31/20X1$260$7,260 (1)06/30/20X21957,195 (2)12/31/20X21307,130 (3)06/30/20X3657,065 (4)12/31/20X30$7,000 Change in Carrying Value $260 / 4 semiannual periods = $65 per period 12/31/20X126012/31/20X17,000 06/30/20X265 12/31/20X265 06/30/20X365 12/31/20X365 12/31/20X30 7,000 A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the premium. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20X1; (c ) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20X3. Premium on Bonds PayableBonds Payable Unamortized Premium << $7,000 x = $7,260 P3 29

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. DebitCredit 12/31/20X1 Cash($7,000 x )7,260 Premium on Bonds Payable260 Bonds Payable7,000 General Journal 12/31/20X126012/31/20X17,000 06/30/20X265 12/31/20X265 06/30/20X365 12/31/20X365 12/31/20X30 7,000 Premium on Bonds PayableBonds Payable Interest expense = Amount repaid minus amount borrowed 4 payments of $280$1,120 1 payment of $7,0007,000 Total repaid8,120 Borrowed7,260 Total bond interest expense$ 860÷ 4 = $215 per period Semiannual payment = $280 ($7,000 x 8% x ½) P3 30

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. DebitCredit 06/30/20X2 Bond Interest Expense($280 - $65)215 Premium on Bonds Payable65 Cash($7,000 x 8% x ½)280 12/31/20X2 Bond Interest Expense($280 - $65)215 Premium on Bonds Payable65 Cash($7,000 x 8% x ½)280 06/30/20X3 Bond Interest Expense($280 - $65)215 Premium on Bonds Payable65 Cash($7,000 x 8% x ½)280 12/31/20X3 Bond Interest Expense($280 - $65)215 Premium on Bonds Payable65 Cash($7,000 x 8% x ½)280 General Journal 12/31/20X126012/31/20X17,000 06/30/20X265 12/31/20X265 06/30/20X365 12/31/20X365 12/31/20X30 7,000 Premium on Bonds PayableBonds Payable Semiannual payment = $280 ($7,000 x 8% x ½) P3 31

NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. DebitCredit 12/31/20X3 Bonds Payable7,000 Cash7,000 General Journal 12/31/20X126012/31/20X17,000 06/30/20X265 12/31/20X265 06/30/20X365 12/31/20X365 12/31/20X30 7,000 Premium on Bonds PayableBonds Payable Semiannual payment = $280 ($7,000 x 8% x ½) P3 32

Bond Pricing P3 Cash Outflows related to Interest Payments Cash Outflows for par value at end of Bond life 33

Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: ? Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: ? Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) P3 Present Value of a Discount Bond 34

Present Value of a Discount Bond To calculate Present Value, we need relevant interest rate and number of periods. Semiannual rate = 5% (Market rate 10% ÷ 2) Semiannual periods = 4 (Bond life 2 years × 2) To calculate Present Value, we need relevant interest rate and number of periods. Semiannual rate = 5% (Market rate 10% ÷ 2) Semiannual periods = 4 (Bond life 2 years × 2) $100,000 × 8% × ½ = $4,000 P3 35

10-P4:Bond Retirement 36

Bond Retirement Retirement of the Fila bonds at maturity for $100,000 cash. Because any discount or premium will be fully amortized at maturity, the carrying value of the bonds will be equal to par value. P4 37

Bond Retirement Retirement of Bonds before Maturity Carrying Value > Retirement Price = Gain Carrying Value < Retirement Price = Loss Assume that $100,000 of callable bonds will be retired on July 1, 2015, after the first interest payment. The bond carrying value is $104,500.The bonds have a call premium of $3,000. P4 38

Bond Retirement Conversion of Bonds to Stock On January 1, $100,000 par value bonds of Converse, with a carrying value of $100,000, are converted to 15,000 shares of $2 par value common stock. 15,000 shares × $2 par value per share P4 39

10-C1:Installment Notes 40

Note Maturity Date Note Payable Cash CompanyLender Note Date When is the repayment of the principal and interest going to be made? Long-Term Notes Payable C1 41

Note Maturity Date CompanyLender Note Date Single Payment of Principal plus Interest Long-Term Notes Payable C1 Single Payment of Principal plus Interest 42

Note Maturity Date CompanyLender Note Date Regular Payments of Principal plus Interest Long-Term Notes Payable C1 43

Installment Notes On January 1, 2015, Foghog borrows $60,000 from a bank to purchase equipment. It signs an 8% installment note requiring 6 annual payments of principal plus interest. Compute the periodic payment by dividing the face amount of the note by the present value factor. C1 44

Installment Notes with Equal Payments C1 45

Installment Notes with Equal Payments Let’s record the first payment made on December 31, 2015 by Foghog to the bank. Refer back to the amortization schedule to make the December 31, 2016 payment on the note. C1 46

Mortgage Notes and Bonds A mortgage is a legal agreement that helps protect the lender if the borrower fails to make the required payments. It gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. C1 47

$1,000 = Present Value of an Ordinary Annuity $1,000 = PVA (n=4, i=5%) x Payment On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. 1. Compute the amount of each of the four equal total payments. $1,000 = Payment PVA (n=4, i=5%) NEED-TO-KNOW PV of $1 FV of $1 PV Ord Ann FV Ord Ann C1/P5 48

C1/P5 49

$1,000 = Present Value of an Ordinary Annuity $1,000 = PVA (n=4, i=5%) x Payment = Payment On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. 1. Compute the amount of each of the four equal total payments. $1,000 = Payment $1,000 = Payment $282 PVA (n=4, i=5%) NEED-TO-KNOW PV of $1 FV of $1 PV Ord Ann FV Ord Ann C1/P5 50

2. Prepare an amortization table for this installment note. Period End (A) Beginning Balance (B) Debit Interest Expense [5% x (A)] (C) Debit Notes Payable [(D) - (B)] (D) Credit Cash (E) Ending Balance [(A) - (C)] 12/31/20X1$1,000$50$232$282$768 12/31/20X /31/20X /31/20X $128$1,000$1,128 On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. 1. Compute the amount of each of the four equal total payments. $282 NEED-TO-KNOW 3. Prepare journal entries to record the loan on January 1, 20X1, and the four payments from December 31, 20X1, through December 31, 20X4. C1/P5 51

Period End (A) Beginning Balance (B) Debit Interest Expense [5% x (A)] (C) Debit Notes Payable [(D) - (B)] (D) Credit Cash (E) Ending Balance [(A) - (C)] 12/31/20X1$1,000$50$232$282$768 12/31/20X /31/20X /31/20X426814* DebitCredit 01/01/20X1 Cash1,000 Notes payable1,000 12/31/20X1 Interest expense($1,000 x.05)50 Notes payable232 Cash282 12/31/20X2 Interest expense($768 x.05)38 Notes payable244 Cash282 12/31/20X3 Interest expense($524 x.05)26 Notes payable256 Cash282 12/31/20X4 Interest expense(* Rounded)14 Notes payable268 Cash282 General Journal NEED-TO-KNOW C1/P5 52

Global View Accounting for Bonds and Notes The definitions and characteristics of bonds and notes are broadly similar for both U.S. GAAP and IFRS. The accounting for issuances of bonds, market pricing, and retirement of both bonds and notes is similar. Both U.S. GAAP and IFRS also allow companies to account for bonds and notes using fair value. Accounting for Leases and Pensions Both U.S. GAAP and IFRS require companies to distinguish between operating leases and capital leases; with IFRS calling the latter finance leases. The accounting and reporting for leases are broadly similar, with the main difference that the criteria for identifying a lease as a capital or finance lease is more general under IFRS. For pensions, the methods of accounting and reporting are similar for both U.S. GAAP and IFRS. 53

10-A2:Features of Bonds and Notes 54

Secured and Unsecured Term and Serial Registered and Bearer Convertible and Callable Features of Bonds and Notes A2 55

10-A3:Debt-to-Equity Ratio 56

This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity. Debt-to-Equity Ratio Debt-to- equity ratio Total liabilities Total equity = A3 57

10-C2:Present Values of Bonds and Notes 58

Present Value of $1 Rate Periods3%4%5% Appendix 10A: Present Values of Bonds and Notes Face amount = $100,000 Contract rate = 8% Market rate = 10% Interest paid semiannually First, we calculate the present value of the principal repayment in 4 periods (2 years × 2 payments per year, using 5% market rate (10% annual rate ÷ 2 payments per year). $100,000 × = $82,270 C2 59

Present Value of Annuity of $1 Rate Periods3%4%5% Appendix 10A: Present Values of Bonds and Notes $100,000 × 8% × ½ = $4,000 Semiannual Interest Annuity Present AmountPV FactorValue Principal $ 100, $ 82,270 Interest 4, ,184 Issue price of debt $ 96,454 $4,000 × = $14,184 C2 60

10-P5:Effective Interest Amortization of a Discount Bond 61

Appendix 10B: Effective Interest Amortization P5 Effective Interest Amortization of Bond Discount Stated Rate: 8% Effective Rate: 10% 62

10-P6:Effective Interest Amortization of a Premium Bond 63

Appendix 10B: Effective Interest Amortization P6 Effective Interest Amortization of Bond Premium Stated Rate: 12% Effective Rate: 10% 64

10-C3:Issuing Bonds between Interest Dates 65

Appendix 10C: Issuing Bonds Between Interest Dates Avia sells $100,000 of its 9% bonds at par on March 1, 2015, 60 days after the stated issue date. The interest on Avia bonds is payable semiannual on each June 30 and December 31. Stated Issue date 1/1 Date of sale 3/1 First Interest date 6/30 $1,500 accrued $3,000 earned Bondholder pays $1,500 to issuer Issuer pays $4,500 to bondholder C3 66

10-C4:Leases and Pensions 67

Appendix 10D: Leases and Pensions A lease is a contractual agreement between the lessor (asset owner) and the lessee (asset renter or tenant) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. Operating Leases Operating leases are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. Examples include most car and apartment rental agreements. Capital Leases Capital leases are long-term (or non-cancelable) leases by which the lessor transfers substantially all risks and rewards of ownership to the lessee. Examples include leases of airplanes and department store buildings. C4 68

Appendix 10D: Leases and Pensions A pension is a contractual agreement between an employer and its employees for the employer to provide benefits (payments) to employees after they retire. Defined Benefit Plans The employer’s contributions vary, depending on assumptions about future pension assets and liabilities. A pension liability is reported when the accumulated benefit obligation is more than the plan assets, a so-called underfunded plan. C4 69

End of Chapter 10 70