Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition Wild, Shaw, and Chiappetta Fifth Edition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 10 Long-Term Liabilities

Conceptual Learning Objectives C1: Explain the types and payment patterns of notes. C2: Appendix 10A – Explain and compute the present value of an amount(s) to be paid at a future date(s). C3: Appendix 10C – Describe interest accrual when bond payment periods differ from accounting periods. C4: Appendix 10D – Describe accounting for leases and pensions (see text for details). 10-3

A1: Compare bond financing with stock financing. A2: Assess debt features and their implications. A3: Compute the debt-to-equity ratio and explain its use. Analytical Learning Objectives 10-4

P1: Prepare entries to record bond issuance and interest expense. P2: Compute and record amortization of bond discount using straight-line method. P3: Compute and record amortization of bond premium using straight-line method. P4: Record the retirement of bonds. P5: Prepare entries to account for notes. P6: Appendix 10B- Compute and record amortization of bond discount using effective interest method. P7: Appendix 10B- Compute and record amortization of bond premium using effective interest method. Procedural Learning Objectives 10-5

Bonds do not affect owner control. Interest on bonds is tax deductible. Bonds can increase return on equity. Advantages of Bonds A1 10-6

Bonds require payments of both periodic interest and par value at maturity. Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds. Disadvantages of Bonds A1 10-7

...an investment firm called an underwriter, resells the bonds to A trustee monitors the bond issue. A company can sell the bonds to... investors Bond-Issuing Procedures A1 10-8

Bond Issue Date Bond Interest Payments CorporationInvestors Interest payment = Bond par value  Contract interest rate x Time Interest payment = Bond par value  Contract interest rate x Time Basics of Bonds A1 10-9

King Co. issues the following bonds on January 1, 2013 Par value = $1,000,000 Stated interest rate = 10% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2032 (20 years) King Co. issues the following bonds on January 1, 2013 Par value = $1,000,000 Stated interest rate = 10% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2032 (20 years) Issuing Bonds at Par P

Interest payment is: $1,000,000 × 10% × ½ year = $50,000 This entry is made every six months until the bonds mature. Interest Expense on Bonds at Par The entry on June 30, 2013, to record the first semiannual interest payment is... P

On Dec. 31, 2032 when the bonds mature, King Co. makes the following entry... Issuing Bonds at Par The debt has now been extinguished. P

Bond Discount or Premium P Dow Chemical Company $1, % paid semiannually on 6/30 and 12/31 Due (matures) on 2033 Contract rate

Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1,000,000 Issue price = % of par value Stated interest rate = 10% Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1,000,000 Issue price = % of par value Stated interest rate = 10% Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Issuing Bonds at a Discount } Bond will sell at a discount. P

Amortizing the discount increases interest expense over the outstanding life of the bond. Amortizing the discount increases interest expense over the outstanding life of the bond. $1,000,000  % Issuing Bonds at a Discount P

Contra-Liability Account Contra-Liability Account On Jan. 1, 2013, Rose Co. would record the bond issue as follows: Issuing Bonds at a Discount P Bonds Payable Discount on Bonds Payable 73,595 1,000,000

Maturity Value Carrying Value Using the straight-line method, the discount amortization will be $7,360 every six months. $73,595 ÷ 10 periods = $7,360* *(rounded) Using the straight-line method, the discount amortization will be $7,360 every six months. $73,595 ÷ 10 periods = $7,360* *(rounded) P Making the First Interest Payment and Amortizing the Discount

$73,595 ÷ 10 periods = $7,360 (rounded) $1,000,000 × 10% × ½ = $50,000 $73,595 ÷ 10 periods = $7,360 (rounded) $1,000,000 × 10% × ½ = $50,000 Make the following entry every six months to record the cash interest payment and the amortization of the discount. Making the First Interest Payment and Amortizing the Discount P

P Straight-Line Amortization of Bond Discount

Periodic interest amounts will differ but total interest expense, over the life of the bond, will be the same. Straight-Line and Effective Interest Methods P $ Life of the Bond

Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1,000,000 Issue price = % of par value Stated interest rate = 10% Market interest rate = 8% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1,000,000 Issue price = % of par value Stated interest rate = 10% Market interest rate = 8% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Issuing Bonds at a Premium } Bond will sell at a premium. P

Amortizing the premium decreases interest expense over the life of the bond. Amortizing the premium decreases interest expense over the life of the bond. $1,000,000  % Issuing Bonds at a Premium P

Adjunct-Liability (or accretion) Account Adjunct-Liability (or accretion) Account On Jan. 1, 2013, Rose Co. would record the bond issue as follows. Issuing Bonds at a Premium P ,145 Bonds Payable Premium on Bonds Payable 1,000,000

Using the straight-line method, the premium amortization will be $8,115 every six months. $81,145 ÷ 10 periods = $8,115 (rounded) Using the straight-line method, the premium amortization will be $8,115 every six months. $81,145 ÷ 10 periods = $8,115 (rounded) P Making the First Interest Payment and Amortizing the Bond Premium Maturity Value Carrying Value

$81,145 ÷ 10 periods = $8,115 (rounded) $1,000,000 × 10% × ½ = $50,000 $81,145 ÷ 10 periods = $8,115 (rounded) $1,000,000 × 10% × ½ = $50,000 This entry is made every six months to record the cash interest payment and the amortization of the premium. P Making the First Interest Payment and Amortizing the Bond Premium

P Straight-Line Amortization of Bond Premium

Bond Retirement The carrying value of the bond at maturity always equals its par value. Sometimes bonds are retired prior to their maturity. Two common ways to retire bonds before maturity are through the exercise of a callable option or through purchasing them on the open market. Callable bonds present several accounting issues including calculating gains and losses. P

Before Maturity Carrying value > Retirement price = Gain Carrying value < Retirement price = Loss Bond Retirement P

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

Note Maturity Date CompanyLender Note Issuance Date Long-Term Notes Payable Single Payment of Principal plus Interest Single Payment of Principal plus Interest (at maturity) C

Note Maturity Date Company Lender Note Issuance Date Long-Term Notes Payable Regular Payments of Principal plus Interest Payments can either be equal principal payments plus interest or equal payments. Regular Payments of Principal plus Interest C (Over the life of the bond)

Installment Notes with Equal Principal Payments The principal payments are $10,000 each year. Interest expense decreases each year. The principal payments are $10,000 each year. Interest expense decreases each year. Annual payments decrease. C1, P

Installment Notes with Equal Payments The principal payments increase each year. Interest expense decreases each year. Annual payments are constant. C

A legal agreement that helps protect the lender if the borrower fails to make the required payments. 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. A legal agreement that helps protect the lender if the borrower fails to make the required payments. 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. Mortgage Notes and Bonds P

Secured or Unsecured Term or Serial Registered or Bearer Convertible and/or Callable Types of Bonds A

A measure to assess the risk of a company’s financing structure. Industries that are more variable and less stable tend to have lower ratios, while more stable industries tend to have higher ratios. A measure to assess the risk of a company’s financing structure. Industries that are more variable and less stable tend to have lower ratios, while more stable industries tend to have higher ratios. Debt-to-Equity Ratio Debt-to- Equity ratio Total liabilities Total equity = A

Calculate the issue price of Rose Co.’s bonds. Par value = $1,000,000 Issue price = ? Stated interest rate = 10% Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Calculate the issue price of Rose Co.’s bonds. Par value = $1,000,000 Issue price = ? Stated interest rate = 10% Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Figuring the Present Value of a Bond C

Figuring the Present Value of a Bond 1. Semiannual rate = 6% (Market rate 12% ÷ 2) 2. Semiannual periods = 10 (Bond life 5 years × 2) 1. Semiannual rate = 6% (Market rate 12% ÷ 2) 2. Semiannual periods = 10 (Bond life 5 years × 2) $1,000,000 × 10% × ½ = $50,000 C

Effective Interest Method of Amortizing a Discount or Premium The effective interest method allocates total bond interest expense over a changing carrying value. It yields a constant rate of interest over the life of the bond equal to the market rate at time of issuance. Carrying Value of the bond x Market Rate x Time Interest Expense = P6, P

Accrued interest Investor pays bond purchase price + accrued interest. Jan. 1, 2013 Bond Date Apr. 1, 2013 Bond Issue Date June 30, 2013 First Interest Payment Issuing Bonds between Interest Dates C

Accrued interest Jan. 1, 2013 Bond Date Apr. 1, 2013 Bond Issue Date June 30, 2013 First Interest Payment Issuing Bonds between Interest Dates Investor receives 6 months’ interest. Earned interest C

Prepare the entry to record the following bond issue by King Co. on Apr. 1, Par value = $1,000,000 Stated interest rate = 10% Market interest rate = 10% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) Issuing Bonds between Interest Dates C

At the date of issue, the following entry is made: Issuing Bonds between Interest Dates The first interest payment on June 30, 2013 is: C

Jan. 1Apr. 1 Dec. 31 End of accounting period Oct. 1 Interest Payment Dates At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment. 3 months’ accrued interest Accruing Bond Interest Expense at Year End for a Partial Bond Interest Period. C

End of Chapter