1 Chapter 10 Long-Term Liabilities Bonds Payable and other long-term debt are issued by a company to generate cash flow. Bonds Payable represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. The present value of the cash flows is the amount at which the bonds will issue.

2 Bonds Payable Issued for financing purposes. Advantages compared to issuing equity (ex: common stock) – do not affect ownership control. – interest on bonds is tax deductible (dividends are not deductible). – can increase return on equity, if returns are greater than interest incurred. Disadvantages compared to issuing equity – can decrease return on equity, if returns are less than interest incurred. – interest payments are required to prevent default (where dividends are not required).

3 Illustration 1: Bond Issue Price On July 1, 2005, Camero Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = $100,000 (2) Stated Interest = Face value x stated rate x time period 100,000 x.07 x 1/2 = $3,500 Number of periods = n = 5 yrs x 2 = 10 Discount rate = 6% / 2 = 3% per period

4 Illustration 1 - Solution PV of interest annuity: PVA Table PVA Table PVOA = A( ) = 3,500 (8.530) = $29,855 i, n i = 3%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.744)=$74,400 i, n i=3%, n=10 Total issue price = $104,255 Issued at a premium of $4,255 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

5 Illustration 1 - Discount Assume bonds issued to yield 8% annually (or 4% per semiannual period): PV of interest annuity: PVA Table PVA Table PVOA = A( ) = 3,500 (8.111) = $28,389 i, n i = 4%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.676) = $67,600 i, n i=4%, n=10 Total issue price = $95,989 Issued at a discount of $4,011 because the company was offering an interest rate less than the market rate, and investors would only invest if they could pay less than face value for the lower interest rate.

6 Journal Entries for Bonds Payable Bonds may be issued at face value, or at an amount greater than face value (premium), or an amount less than face value (discount). The amount of the stated interest rate offered by the company affects the price of the bond issue: – Higher than market rate: issue at a premium – Lower than market rate: issue at a discount Premium on B/P: (adjunct account) adds to bonds payable (normal credit balance) Discount on B/P: (contra account) reduces bonds payable (normal debit balance Carrying value of bonds = Face value + premium or Face value - discount

7 Illustration 2: Bonds Payable On July 1, 2007, Mustang Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, The bonds were issued at 104% of face value. Cash received? 104% of 100,000 = $104,000 Prepare the journal entry to record the issue of the bond: Cash 104,000 Bonds Payable100,000 (face) Premium on B/P 4,000

8 Illustration 2 -Amortization of Premium The premium represents a “benefit” to the company, because the company is only required to pay the stated interest and face value. At issue, the balance sheet shows Bonds Payable$100,000 Premium on B/P 4,000$104,000 At maturity, only the face value is owed. The balance in the premium account must be amortized to zero, over the life of the bond. The amortization of the benefit decreases interest expense over the life of the bond.

9 Illustration 2 - Amortization Calculation To recognize amortization of premium or discount, we use the straight line method: Cash paid = Face x Stated Rate x Time = 100,000 x.07 x 1/2 year = $3,500 (this is the same amount every period) Premium amortization = Premium / bond life = 4,000/5 years = 800 per yr. x 1/2 year = 400 Interest expense = cash paid - premium amortization = 3, = 3,100 Note that the premium account is amortized with a debit, and the carrying value of the bond is amortized down to face value by maturity.)

10 Illustration 2 - Journal Entries JE at 12/31/07 to pay interest: Note that the numbers for each interest payment are the same each payment, because the straight- line method is used. JE at 6/30/2012 to retire the bonds:

11 Illustration 2 - Amortization Schedule Cash Interest Carrying Date Paid Expense Amort. Value 7/01/07 104,000 12/31/07 3,500 3, ,600 6/30/08 3,500 3, ,200 12/31/08 3,500 3, ,800 6/30/09 3,500 3, ,400 12/31/09 3,500 3, ,000 6/30/10 3,500 3, ,600 12/31/10 3,500 3, ,200 6/30/11 3,500 3, ,800 12/31/11 3,500 3, ,400 6/30/12 3,500 3, ,000

12 Bonds Payable at a Discount. If bonds are issued at a discount, the carrying value will be below face value at the date of issue. The Discount on B/P account has a normal debit balance and is a contra to B/P. The Discount account is amortized with a credit. Note that interest expense now equals the sum of the Cash Paid and the amount of the amortization. Int. expense = cash paid + discount amort. The company incurs additional interest expense because the discount is a cost to the company (must still pay back face value).

13 Illustration 3: Bonds Payable (Discount) On January 1, 2006, Corvette Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 5%, and pay interest annually each December 31, starting December 31, The bonds were issued at 96% of face value. Calculate the cash received for the bond: 96% of 100,000 = $96,000 Issued at a discount of $4,000

14 Illustration 3 : Journal Entry at Issue JE at 1/1/06 to issue the bonds: Discount on Bonds Payable is located in the liability section of the balance sheet, as a contra, and offsets Bonds Payable. On the balance sheet at 1/1/06: Liabilities: Bonds Payable Discount on B/P

15 Illustration 3 : Journal Entry to Pay Interest JE at 12/31/06 to pay interest: Calculations first: Cash paid=Face x stated rate x time = = 100,000 x.05 x 1 yr. = $5,000 Amortization of discount = = 4,000/5 = 800 per year Interest expense = 5, = $5,800 Now journal entry:

16 Retirement of Bonds Bonds are retired when the company pays the investors the amount owed. If bonds are held to maturity, the amount on the books is face value and the amount paid is face value. If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized.

17 Retirement of Bonds The gain or loss is the difference between carrying value and cash paid. – If cash paid is greater than CV, recognize loss (paid more than book liability). – If cash paid is less than CV, recognize gain (paid less than book liability). When recording the early retirement, we must remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount). The gain or loss is recognized as part of Income from Continuing Operations (Other Revenues and Gains or Other Expenses and Losses).

18 Back to Illustration 2 – Bond Retirement Assume that Mustang’s bonds were retired on June 30, 2008 (after the interest payment). Mustang Corporation paid $103,000 to retire the bonds from the marketplace. Record the entries on June 30, JE at 6/30/08 to pay the interest (see Slide 10): JE at 6/30/08 to retire the bonds (CV = 103,200; see amort. Schedule. Slide 11):