Copyright © 2007 Prentice-Hall. All rights reserved 1 Long-Term Liabilities Chapter 15

Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Account for bonds payable

Copyright © 2007 Prentice-Hall. All rights reserved 3 Bonds: An Introduction Groups of notes payable issued to multiple lenders Principal (maturity value, par value) Maturity date Stated interest rate

Copyright © 2007 Prentice-Hall. All rights reserved 4 Types of Bonds Term bonds - mature at a single specified future date Serial bonds - mature in installments

Copyright © 2007 Prentice-Hall. All rights reserved 5 Types of Bonds Secured bonds - specific assets are pledged as collateral Debenture bonds - backed by the good faith of the issuer

Copyright © 2007 Prentice-Hall. All rights reserved 6 Bond Prices Maturity value (par) Discount Premium

Copyright © 2007 Prentice-Hall. All rights reserved 7 Bond Prices Quoted as percent of its face value What is the issue price of a $1,000 bond sold at 98? $1,000 x.98 = $980 What is the issue price of a $5,000 bond sold at 101? $5,000 x 1.01 = $5,050

Copyright © 2007 Prentice-Hall. All rights reserved 8 Present Value Time value of money Amount a person would invest today to receive a greater amount in the future Difference between present value and future value = Interest Yr 1Yr 2Yr 3Yr 4Yr 5 Yr 6 Future Value $100,000 Present Value $97,000

Copyright © 2007 Prentice-Hall. All rights reserved 9 Bond Interest Rates Stated interest rate –Printed on bond –Determines cash interest payments Market interest rate (effective rate) –Rate in effect when bonds are issued –Rate investors demand for loaning money

Copyright © 2007 Prentice-Hall. All rights reserved 10 Bond Interest Rates Bond Stated Rate = 9% Market Rate = 9% Bonds Sell At Par (Face) Market Rate = 8% Bonds Sell at a Premium Market Rate = 10% Bonds Sell at a Discount

Copyright © 2007 Prentice-Hall. All rights reserved 11 GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Issuing Bonds at Par E Mar31Cash400,000 Bonds Payable400,000 Sep30Interest Expense14,000 Cash14,000 Dec31Interest Expense7,000 Interest Payable7,000 Interest = 400,000 x.07 x ½ = 14,000 Interest = 400,000 x.07 x 3/12 = 7,000

Copyright © 2007 Prentice-Hall. All rights reserved 12 GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT E15-17E Mar31Interest Expense7,000 Interest Payable7,000 Cash14,000

Copyright © 2007 Prentice-Hall. All rights reserved 13 E15-18 a GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Jan 1 Cash 50,000 Bonds Payable 50,000 Jul1Interest Expense1,500 Cash1,500 Cash = $50,000 x 6% x ½ = $1,500

Copyright © 2007 Prentice-Hall. All rights reserved 14 Objective 2 Measure interest expense by the straight-line amortization method

Copyright © 2007 Prentice-Hall. All rights reserved 15 GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Bond Discount – E15-18 b Jan 1 Cash 47,500 Discount on Bonds Payable 2,500 Bonds Payable 50,000 Contra-Liability Account

Copyright © 2007 Prentice-Hall. All rights reserved 16 Balance Sheet Presentation as of January 1 Long-term liabilities: Bond payable$50,000 Less Discount on Bonds2,500 $47,500 Face Value Carrying Value

Copyright © 2007 Prentice-Hall. All rights reserved 17 Straight-Line Amortization E15-18 b GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Jan 1 Cash 47,500 Discount on Bonds Payable 2,500 Bonds Payable 50,000 Jul1Interest Expense125 Discount on Bonds Payable125 1Interest Expense1,500 Cash1,500 Amortization of discount = $2,500 / 20 periods Cash = $50,000 x 6% x ½ = $1,500

Copyright © 2007 Prentice-Hall. All rights reserved 18 Balance Sheet Presentation July 1 Long-term liabilities: Bond payable$50,000 Less Discount on Bonds2,375 $ 47,625 January 1 Long-term liabilities: Bond payable$50,000 Less Discount on Bonds2,500 $ 47,500 Notice that the carrying value of the bond increases, approaching the face value

Copyright © 2007 Prentice-Hall. All rights reserved 19 GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Bond Premium – E15-18 c Jan 1 Cash 52,500 Premium on Bonds Payable 2,500 Bonds Payable 50,000

Copyright © 2007 Prentice-Hall. All rights reserved 20 Balance Sheet Presentation as of January 1 Long-term liabilities: Bond payable$50,000 Plus Premium on Bonds2,500 $52,500 Face Value Carrying Value

Copyright © 2007 Prentice-Hall. All rights reserved 21 Straight-Line Amortization E15-18 c GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Jan 1 Cash 52,500 Premium on Bonds Payable 2,500 Bonds Payable 50,000 Jul1Premium on Bonds Payable125 Interest Expense125 1Interest Expense1,500 Cash1,500 Amortization of premium = $2,500 / 20 periods

Copyright © 2007 Prentice-Hall. All rights reserved 22 Balance Sheet Presentation July 1 Long-term liabilities: Bond payable$50,000 Plus Premium on Bonds2,375 $52,375 January 1 Long-term liabilities: Bond payable$50,000 Plus Premium on Bonds2,500 $52,500 Notice that the carrying value of the bond decreases, approaching the face value

Copyright © 2007 Prentice-Hall. All rights reserved 23 Adjusting Entries When bonds are issued at a discount or premium, accrual includes amortization

Copyright © 2007 Prentice-Hall. All rights reserved 24 Issuing Bonds Payable Between Interest Dates Bonds can be issued between interest payment dates

Copyright © 2007 Prentice-Hall. All rights reserved 25 Exercise April 30 Bond Date May 31 Issue Date Oct 31 Interest Payment Date Investor pays face value + Accrued interest $100,000 + $500 ($100,000 x 6% x 1/12) Corp. pays full 6 months’ of interest of $3,000

Copyright © 2007 Prentice-Hall. All rights reserved 26 GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Exercise May 31Cash100,500 Bonds Payable100,000 Interest Payable500 Oct 31Interest Expense2,500 Interest Payable500 Cash3,000 Interest payable = $100,000 x.06 x 1/12

Copyright © 2007 Prentice-Hall. All rights reserved 27 Objective 3 Account for retirement and conversion of bonds payable

Copyright © 2007 Prentice-Hall. All rights reserved 28 Bonds Features Convertible bonds - bondholders can convert bonds into common stock Callable bonds –Corporation can call and retire bonds before maturity date –Corporation usually pays a “call price” which is a few percentage points above par value

Copyright © 2007 Prentice-Hall. All rights reserved 29 Retirement of Bonds Payable To retire a bond early, issuer can –Purchase bonds in the open market –Exercise a call option

Copyright © 2007 Prentice-Hall. All rights reserved 30 Early Retirement of Bonds Record interest expense and amortize discount or premium up to retirement date If carrying value of bond > cash paid = gain on early retirement of bonds If carrying value of bond < cash paid = loss on early retirement of bonds Gains or losses on early retirement of debt (if material in amount) are extraordinary items

Copyright © 2007 Prentice-Hall. All rights reserved 31 E15-24E15-24 Bonds payable 200,000 Discount on bonds 12,000 Carrying value of bonds Bonds payable100,000 Less discount (6,000) 94,000 Cash paid to retire debt 100,000 x 1.01 = 101,000 Loss of 7, ,000 x ½ 12,000 x ½

Copyright © 2007 Prentice-Hall. All rights reserved 32 E15-24 (1) GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Oct1Bonds Payable100,000 Loss on Retirement of Bonds Payable 7,000 Discount on Bonds Payable6,000 Cash101,000

Copyright © 2007 Prentice-Hall. All rights reserved 33 Convertible Bonds Holder has option of exchanging bond for specified number of shares of common stock When converted - stockholders’ equity increased by carrying amount of bonds converted

Copyright © 2007 Prentice-Hall. All rights reserved 34 E15-24 (2) GENERAL JOURNAL DATEDESCRIPTIONREFDEBITCREDIT Oct1Bonds Payable100,000 Discount on Bonds Payable6,000 Common Stock10,000 Paid-in Capital in Excess of Par, Common84,000 The bondholders would convert their bonds into stock when the market value of the stock to be received from conversion exceeds the market value of the bonds

Copyright © 2007 Prentice-Hall. All rights reserved 35 Objective 4 Report liabilities on the balance sheet

Copyright © 2007 Prentice-Hall. All rights reserved 36 Reporting Liabilities Current: –Interest Payable –Current portions of long-term liabilities Long-term: –Mortgage Payable –Capital Lease Payable –Bonds Payable

Copyright © 2007 Prentice-Hall. All rights reserved 37 Exercise Current liabilities: Accounts payable…………………….$50,000 Bonds payable, current………………20,000 Salary payable………………………..10,000 Income tax payable…………………..8,000 Interest payable……………….…..….7,000 Total current liabilities………………$95,000 Long-term liabilities: Bonds payable……………….……...$180,000

Copyright © 2007 Prentice-Hall. All rights reserved 38 Objective 5 Show the advantages and disadvantages of borrowing

Copyright © 2007 Prentice-Hall. All rights reserved 39 Advantages of Bonds Do not affect stockholder control Interest on bonds is tax deductible Can increase return on equity

Copyright © 2007 Prentice-Hall. All rights reserved 40 Disadvantages of Bonds Require payment of both periodic interest and par value at maturity Can decrease return on equity when company pays more in interest than it earns on the borrowed funds

Copyright © 2007 Prentice-Hall. All rights reserved 41 End of Chapter 15