Chapter 10 Long-Term Liabilities Financial Accounting, 11e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Learning Objectives Identify the management issues related to long-term debt. Describe the features of a bond issue and the major characteristics of bonds. Record bonds issued at face value and at a discount or premium. Use present values to determine the value of bonds. Amortize bond discounts and bond premiums using the straight-line and effective interest methods. Account for the retirement of bonds and the conversion of bonds into stock. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Deciding to Issue Long-Term Debt Advantages of issuing common stock over issuing long-term debt: Permanent financing: Not paid back Dividend payout: Optional Advantages of issuing debt over issuing common stock: Stockholder control Tax advantage Financial leverage: A company’s ability to earn more from the funds it raises by incurring long-term debt than it pays in interest on the debt thereby increasing earnings for the stockholders. Despite advantages, debt financing is not always in a company’s best interest because of: Financial risk Negative financial leverage © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Financial Ratio: Debt to Equity Ratio Debt to equity ratio: Amount of debt in relation to stockholders’ equity. The higher the ratio, the greater financial risk. McDonald’s long-term leases do not appear as liabilities on its balance sheet. Off-balance-sheet financing: Long-term commitments of cash payments that have the effect of long-term liabilities but structured so that the commitments do not appear as liabilities on its balance sheet. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Financial Ratio: Interest Coverage Ratio Interest coverage ratio: A measure of the degree of protection a company has from default on interest payments. The lower the ratio, the greater the financial risk. Example: McDonald’s income before taxes is $6,487.0 million and interest expense is $473.2 million: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Types of Long-Term Debt Bonds Payable Notes Payable Mortgages Payable Mortgage: Long-term debt secured by real property, usually paid in equal monthly installments, and each monthly installment includes interest on the debt and a reduction in the debt. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Mortgage Payment (slide 1 of 2) June 1: Mortgage was obtained. Monthly payments are $1,600. Analysis: The journal entry to record the mortgage payments ▼ decreases Mortgages Payable with a debit of $600, ▲ increases Mortgage Interest Expense with a debit of $1,000, and ▼ decreases Cash with a credit of $1,600. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Mortgage Payment (slide 2 of 2) Comment: Notice from the entry and from the monthly payment schedule above that the July 1 payment represents the following: Interest expense: $100,000 x 0.12 x 1/12 = $1,000 Reduction in debt: $1,600 - $1,000 = $600 Therefore, the July payment reduces the unpaid balance to $99,400. August’s interest expense is slightly less than July’s because of the decrease in the debt. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Types of Long-Term Debt: Long-Term Leases Operating asset can obtained: By borrowing money and buying the asset. By renting the asset on a short-term lease. Operating lease: A lease agreement in which asset ownership risks remain with lessor, and lease is shorter than the asset’s useful life. Payments are treated as rent expense. By obtaining the asset on a long-term lease. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Capital Leases Long-term leases can be structured so that they can be accounted for as operating leases. Capital lease: Lease cannot be canceled. Duration is about the same as the useful life of the asset. Option to buy the asset at a nominal price at end of lease. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Capital Leases Recording the Lease (slide 1 of 2) Karma Manufacturing Company enters into a long-term lease for a machine. The lease terms call for an annual payment of $8,000 for six years, which approximates the useful life of the machine. At the end of the lease period, the title to the machine passes to Karma. If Karma’s interest cost on the unpaid part of its obligation is 16 percent, the present value of the lease payments would be computed as follows: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Capital Leases Recording the Lease (slide 1 of 2) Analysis: The journal entry to record the lease ▲ increases Interest Expense with a debit, ▼ decreases Capital Lease Obligations with a credit, and ▼ decreases Cash with a credit. Comment: Capital Lease Equipment is classified as a long-term asset. Capital Lease Obligations is classified as a long-term liability. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Capital Leases Recording the Depreciation (slide 1 of 2) Each year, Karma must record depreciation on the leased asset. (Assume straight-line depreciation, a six-year life, and no residual value.) Analysis: The journal entry to record depreciation ▲ increases Depreciation Expense, Capital Lease Equipment with a debit and, ▲ increases the contra-asset account Accumulated Depreciation, Capital Lease Equipment with a credit. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Capital Leases Recording the Depreciation (slide 2 of 2) Comment: The interest expense for each year is computed by multiplying the interest rate by the amount of the remaining lease obligation: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Capital Leases Recording the Lease Payment Analysis: The journal entry to record the first lease payment ▲ increases Interest Expense with a debit, ▼ decreases Capital Lease Obligations with credit, and ▼ decreases Cash with a credit. Comment: By structuring long-term leases so that they can be accounted for as operating leases, companies avoid recording them on the balance sheet as long-term assets and liabilities. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Types of Long-Term Debt: Pension Liabilities Pension plan: A contract that requires a company to pay benefits to its employees after they retire. Pension fund: A fund established by the contributions of an employer and often of employees from which payments are made to employees after retirement. Defined contribution plan The employer makes a fixed annual contribution as per the agreement between the company and the employees. Defined benefit plan The employer contributes an amount annually required to fund estimated future pension liability arising from employment in the current year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Types of Long-Term Debt Other Postretirement Benefits: Health care and other benefits provided to employees apart from pension. Deferred Income Taxes: A balance sheet account that results from using different accounting methods to calculate income taxes on the income statement and income tax liability on the income tax return. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

© 2012 Cengage Learning. All Rights Reserved © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Match each type of long-term liability listed below with the statement to which it applies. 1. Bonds payable 2. Long-term notes payable 3. Mortgage payable 4. Long-term lease 5. Pension liabilities 6. Other postretirement benefits 7. Deferred income taxes ___ a. Cost of health care after employees’ retirement ___ b. The most common type of long-term debt ___ c. The result of differences between accounting income and taxable income ___ d. Debt that is secured by real estate ___ e. Promissory notes that are due in more than one year ___ f. May be based on a percentage of employees’ wages or on future benefits ___ g. Can be similar in form to an installment purchase SOLUTION a. 6; b. 1; c. 7; d. 3; e. 2; f. 5; g. 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

The Nature of Bonds Bond: A security, usually long term, representing money that a corporation borrows from the investing public. Bond indenture: A contract that defines the rights, privileges, and limitations of the bondholders. Bond certificate: Evidence of a corporation’s debt to the bondholders. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Bond Issue and Prices Bond issue: The total value of bonds issued at one time. Prices are stated in terms of a percentage of the face value, or principal, of the bonds. Example: A bond issue quoted at 103½ means that a $1,000 bond costs $1,035 ($1,000 x 1.035). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Bond Interest Rates Face interest rate: Fixed rate of interest paid to bondholders based on face value of the bonds. Market interest rate (effective interest rate): Rate of interest paid in the market on bonds of similar risk. Discount: The excess of the face value over the issue price. The issue price will be less than the face value when the market interest rate is higher than the face interest rate. Premium: The excess of the issue price over the face value. The issue price will be more than the face value when the market interest rate is lower than the face interest rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Characteristics of Bonds (slide 1 of 3) Unsecured bonds (debenture bonds): Bonds issued on an organization’s general credit. Secured bonds: Bonds that carry a pledge of certain assets as a guarantee of repayment. Term bonds: Bonds in one issue that mature at the same time. Serial bonds: Bonds in one issue that mature on different dates. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Characteristics of Bonds (slide 2 of 3) Callable and convertible bonds Early extinguishment of debt: When a company retires a bond issue before its maturity date. Callable bonds: Bonds that the issuing corporation can buy back and retire at call price before their maturity dates. Convertible bonds: Bonds that can be exchanged for shares of common stock. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Characteristics of Bonds (slide 3 of 3) Registered bonds: Bonds that the issuing company registers in the names of the bondholders. Coupon bonds: Bonds not registered with the issuing organization that bear coupons stating the amount of interest due and the payment date. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

SOLUTION Match each term below with the related term. 1. Face interest rate 2. Discount 3. Unsecured 4. Term 5. Registered 6. Callable 7. Non-convertible 8. Deferred income taxes ___ a. Secured ___ b. Coupon ___ c. Convertible ___ d. Premium ___ e. Market interest rate ___ f. Serial ___ g. Non-callable SOLUTION a. 3; b. 5; c. 6; d. 2; e. 1; f. 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at Face Value (slide 1 of 3) Bond: Zumi Corporation issues $200,000 of 9 percent, five-year bonds on January 1, 2011, and sells them on the same date for their face value. The bond indenture states that interest is to be paid on January 1 and July 1 of each year. Analysis: The journal entry to record the issuance of bonds at face value ▲ increases Cash with a debit and ▲ increases Bonds Payable with a credit. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at Face Value (slide 2 of 3) Interest Expense: Once a corporation issues bonds, it must pay interest to the bondholders over the life of the bonds and the principal of the bonds at maturity. Here, interest is paid on January 1 and July 1 of each year. Thus, Zumi would owe the bondholders $9,000 interest on July 1, 2011: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at Face Value (slide 3 of 3) Analysis: The journal entry to record the interest paid to the bondholders on each semiannual interest payment date (January 1 or July 1) ▲ increases Bond Interest Expense with a debit and ▼▲ decreases Cash with a credit (or increases Interest Payable with a credit). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at a Discount (slide 1 of 2) Bond: Zumi issues $200,000 of 9 percent, five-year bonds at 96.149 on January 1, 2011, when the market interest rate is 10 percent. Analysis: The entry to record the issuance of the bonds at a discount ▲ increases Cash with a debit for the amount of the bond issue less the discount, ▲ increases Unamortized Bond discount with a debit for the amount of discount, and ▼ increases Bonds Payable with a credit for the amount of the bond issued. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at a Discount (slide 2 of 2) Comment: If a balance sheet is prepared immediately after the bonds are issued at a discount, the liability for bonds payable is reported as follows: Unamortized Bond Discount is a contra-liability account. Its balance is deducted from the face amount of the bonds to arrive at the carrying value (present value) of the bonds. The unamortized bond discount will be amortized (written off) over the life of the bonds. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at a Premium (slide 1 of 2) Bond: Zumi issues $200,000 of 9 percent, five-year bonds for $208,200 on January 1, 2011, when the market interest rate is 8 percent. Analysis: The journal entry to record the bond issue at a premium ▲ increases the Cash for amount of the bond issue plus the premium, ▲ increases the Unamortized Bond Premium for the amount of the premium, and ▲ increases the Bonds Payable account for the amount of the bond issue. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Bonds Issued at a Premium (slide 2 of 2) Comment: Immediately after this entry is made, bonds payable would appear on the balance sheet as follows: Here, the carrying value of the bonds payable ($208,200) equals the face value of the bonds plus the unamortized bond premium. This means that the purchasers were willing to pay a premium ($8,200) to buy these bonds because their face interest rate was higher than the market interest rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Bond Issue Costs The costs of issuing bonds can amount to as much as 5 percent of a bond issue. Costs include underwriters fees hired to take care of the details of marketing a bond issue. Issue costs benefit the whole life of a bond issue, costs spread over that period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Gill Foods is planning to issue $1,000,000 in long-term bonds Gill Foods is planning to issue $1,000,000 in long-term bonds. Depending on market conditions, Gill’s CPA advises that the bonds could be issued at (a) 99, (b) 100, or (c) 101. Calculate the amount that Gill would receive under each alternative; indicate whether it is at face value, a discount, or a premium; and include the amount of the discount or premium. SOLUTION $1,000,000 × 0.99 = $990,000; a discount of $10,000 $1,000,000 × 1.00 = $1,000,000; at face value; no discount or premium $1,000,000 × 1.01 = $1,010,000; a premium of $10,000 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Using Present Value to Value a Bond (slide 1 of 2) A bond has a face value of $20,000 and pays fixed interest of $900 every six months (a 9% annual rate). The bond is due in 5 years. If the market interest rate today is 12%, what is the present value of the bond? Case 1: Market Rate Above Face Rate Present value of 10 periodic payments at 6%: ($900 x 7.360*) $ 6,624 Present value of a single payment of at the end of 10 periods at 6% ($20,000 x 0.558*) 11,160 Present value of the $20,000 bond $17,784 * From the Present Value Tables in Appendix B of the textbook. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Using Present Value to Value a Bond (slide 2 of 2) If the market interest rate on the bond described previously falls below the face interest rate, say to 8% (4% semiannually), the present value of the bond will be greater than the face value of $20,000 Case 2: Market Rate Below Face Rate Present value of 10 periodic payments at 4% ($900 x 8.111*) $ 7,300 Present value of a single payment at the end of 10 periods at 4% ($20,000 x 0.676*) 13,520 Present value of the $20,000 bond $20,820 * From the Present Value Tables in Appendix B of the textbook. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Using Present Value to Value a $20,000, 9%, Five-Year Bond © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Tyler Company’s $500,000 bond issue pays semiannual interest of $16,000 and is due in 20 years. Assume that the market interest rate is 6 percent. Calculate the amount that Tyler will pay at maturity. (Calculate the present value of each bond issue and sum.) Solution Present value of 40 periodic payments of 3%: $16,000 × 23.115* = $369,840 Present value of a single payment at the end of 40 years (40 periods) at 3%: $500,000 × 0.307* = $153,500 Total value of the bond issue = $523,340 * From the Present Value Tables in Appendix B of the textbook. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Interest Expense for Bonds Issued at a Discount When a corporation issues bonds at a discount, the market interest rate that it pays is greater than the face interest rate on the bonds. The interest expense is the stated interest payments plus the amount of the bond discount. Although the company does not receive the full face value of the bonds on issue, it still must pay back the full face value at maturity. The difference between the issue price and the face value must be added to the total interest payments to arrive at the actual interest expense. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Calculating Total Interest Expense for a Bond Discount (slide 1 of 3) Bond: Zumi issued $200,000 of five-year bonds at a time when the market interest rate (10%) exceeded the face interest rate (9%). The bonds sold for $192,298, resulting in an unamortized bond discount of $7,702. The interest payment dates of the bond issue are January 1 and July 1 of each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Calculating Total Interest Expense for a Bond Discount (slide 2 of 3) Analysis: The journal entry to record the bond issue ▲ increases the Cash account with a debit for $192,298, ▲ increases the Unamortized Bond Discount account with a debit for $7,702, and ▲ increases the Bonds Payable account with a credit for $200,000. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Calculating Total Interest Expense for a Bond Discount (slide 3 of 3) Comment: Zumi’s total expense of issuing its bonds at a discount can be calculated as follows: The total interest expense ($97,702) is made up of $90,000 in interest payments and the $7,702 bond discount. Thus, the bond discount increases the interest paid on the bonds from the face interest rate to the market interest rate. The market interest rate is the real interest expense of the bond over its life. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Bond Amortization Because a bond discount affects interest expense in each year of a bond issue, the bond discount should be amortized over the life of the bond issue. The unamortized bond discount will decrease over time. The carrying value of the bond issue (face value less unamortized discount) will increase over time. By maturity, the carrying value of the bond issue will equal its face value, and the unamortized bond discount will be zero. Bonds only have to be amortized when interest is periodically paid. Zero coupon bond: Bonds that do not pay periodic interest but that pay a fixed amount on the maturity date. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Methods for Amortizing a Bond A company can amortize its bond discount or premium using the following methods: Straight-line method: A method of amortizing bond discounts or premiums that allocates the discount or premium equally over each interest period in the life of the bonds. Effective interest method: A method of amortizing bond discounts or premiums that applies a constant interest rate (the market rate when the bonds were issued) to the carrying value of the bonds at the beginning of each interest period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Straight-Line Method (slide 1 of 4) Bond: Zumi issued $200,000 of five-year bonds at a time when the market interest rate (10%) exceeded the face interest rate (9%). The bonds sold for $192,298, resulting in an unamortized bond discount of $7,702. The interest payment dates of the bond issue are January 1 and July 1 of each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Straight-Line Method (slide 2 of 4) Bond Discount Interest Expense and Amortization: With the straight-line method, the amount of the bond discount amortized and the interest expense for each semiannual period are calculated in four steps: Step 1: Determine the total number of interest payments. Step 2: Determine the amount of bond discount amortization per period. * Rounded © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Straight-Line Method (slide 3 of 4) Step 3: Determine the cash payment. Step 4: Determine the interest expense per period. Analysis: The journal entry to record the bond discount amortized and interest expense ▲ increases Bond Interest Expense with a debit for the amount calculated in Step 4, ▼ decreases Unamortized Bond Discount with a credit for the amount calculated in Step 2, and ▲ decreases Cash (or increases Interest Payable) with a credit for the amount in Step 3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Straight-Line Method (slide 4 of 4) Comment: The bond interest expense is $9,770, but the amount paid to the bondholders is the face interest payment ($9,000). The difference ($770) is the credit to Unamortized Bond Discount. This lowers the debit balance of Unamortized Bond Discount and raises the carrying value of the bonds payable by $770 each interest period. If no changes occur in the bond issue, this entry will be made every six months during the life of the bonds. When the bond issue matures, the Unamortized Bond Discount account will have a zero balance, and the carrying value of the bonds will be $200,000—exactly equal to the amount due the bondholders. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Effective Interest Method (slide 1 of 4) Bond: Zumi issued $200,000 of five-year bonds at a time when the market interest rate (10%) exceeded the face interest rate (9%). The bonds sold for $192,298, resulting in an unamortized bond discount of $7,702. The interest payment dates of the bond issue are January 1 and July 1 of each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Effective Interest Method (slide 2 of 4) Bond Discount Interest Expense and Amortization: With the straight-line method, the amount of the bond discount amortized and the interest expense for each semiannual period are calculated in four steps: Step 1: Determine the carrying value of the bonds. Step 2: Determine the interest expense (effective interest). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Effective Interest Method (slide 3 of 4) Step 3: Determine the interest paid in the period (constant amount). Step 4: Determine the amortized discount. Step 5: Determine the unamortized discount. Step 6: Determine the carrying value of the bonds at the end of the period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Interest and Amortization of a Bond Discount: Effective Interest Method Step 1: Column A; Step 2: Column B; Step 3: Column C; Step 4: Column D; Step 5: Column E; Step 6: Column F © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Discount Using the Effective Interest Method (slide 4 of 4) Analysis: The journal entry to record the bond discount amortized and interest expense ▲ increases Bond Interest Expense with a debit for the amount calculated in Step 2, ▼ decreases Unamortized Bond Discount with a credit for the amount calculated in Step 4, and ▲ decreases Cash (or increases Interest Payable) with a credit for the amount in Step 3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Carrying Value and Interest Expense—Bonds Issued at a Discount (slide 1 of 2) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Carrying Value and Interest Expense—Bonds Issued at a Discount (slide 2 of 2) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Calculating Total Interest Expense for a Bond Premium (slide 1 of 3) Bond: Zumi issued $200,000 of five-year bonds at a time when the market interest rate (8%) was below the face interest rate (9%). The bonds sold for $208,200, resulting in an unamortized bond premium of $8,200. The interest payment dates of the bond issue are January 1 and July 1 of each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Calculating Total Interest Expense for a Bond Premium (slide 2 of 3) Analysis: The journal entry to record the bond issue ▲ increases the Cash account with a debit for $192,298, ▲ increases the Unamortized Bond Discount account with a debit for $7,702, and ▲ increases the Bonds Payable account with a credit for $200,000. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Calculating Total Interest Expense for a Bond Premium (slide 3 of 3) Comment: Zumi’s total expense of issuing its bonds at a premium can be calculated as follows: The total interest payments of $90,000 exceed the total interest expense of $81,800 by $8,200, the amount of the bond premium. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Straight-Line Method (slide 1 of 4) Bond: Zumi issued $200,000 of five-year bonds at a time when the market interest rate (8%) was below the face interest rate (9%). The bonds sold for $208,200, resulting in an unamortized bond premium of $8,200. The interest payment dates of the bond issue are January 1 and July 1 of each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Straight-Line Method (slide 2 of 4) Bond Premium Interest Expense and Amortization: With the straight-line method, the amount of the bond premium amortized and the interest expense for each semiannual period are calculated in four steps: Step 1: Determine the total number of interest payments. Step 2: Determine the amount of bond premium amortization per period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Straight-Line Method (slide 3 of 4) Step 3: Determine the cash payment. Step 4: Determine the interest expense per period. Analysis: The journal entry to record the bond premium amortized and interest expense ▲ increases Bond Interest Expense with a debit for the amount calculated in Step 4, ▼ decreases Unamortized Bond Premium with a credit for the amount calculated in Step 2, and ▲ decreases Cash (or increases Interest Payable with a credit) for the amount in Step 3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Straight-Line Method (slide 4 of 4) Comment: The bond interest expense is $8,180, but the amount paid to the bondholders is the face interest payment ($9,000). The difference ($820) is the credit to Unamortized Bond Premium. This raises the carrying value of the bonds payable by $820 each interest period. If no changes occur in the bond issue, this entry will be made every six months during the life of the bonds. When the bond issue matures, the Unamortized Bond Premium account will have a zero balance, and the carrying value of the bonds will be $200,000—exactly equal to the amount due the bondholders. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Effective Interest Method (slide 1 of 4) Bond: Zumi issued $200,000 of five-year bonds at a time when the market interest rate (8%) was below the face interest rate (9%). The bonds sold for $208,200, resulting in an unamortized bond premium of $8,200. The interest payment dates of the bond issue are January 1 and July 1 of each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Effective Interest Method (slide 2 of 4) Bond Premium Interest Expense and Amortization: With the effective interest method, the interest expense decreases slightly each period (Step 2) because the amount of the bond premium amortized increases slightly (Step 4). This occurs because a fixed rate is applied each period to the gradually decreasing carrying value (Step 1). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Interest and Amortization of a Bond Premium: Effective Interest Method Step 1: Column A; Step 2: Column B; Step 3: Column C; Step 4: Column D; Step 5: Column E; Step 6: Column F © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Amortizing a Bond Premium Using the Effective Interest Method (slide 4 of 4) Analysis: The journal entry to record the bond premium amortized and interest expense ▲ increases Bond Interest Expense with a debit for the amount calculated in Step 2, ▼ decreases Unamortized Bond Premium with a debit for the amount calculated in Step 4, and ▲ decreases Cash (or increases Interest Payable) with a credit for the amount in Step 3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Carrying Value and Interest Expense—Bonds Issued at a Premium (slide 1 of 2) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Carrying Value and Interest Expense—Bonds Issued at a Premium (slide 2 of 2) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

On June 1, Rola Corporation issues $4,000,000 of 8 percent, 20-year bonds at 97. Interest is payable semiannually, on May 31 and November 30. Rola’s fiscal year ends on November 30. Using the straight-line method of amortization, prepare journal entries for June 1 and November 30. Using the Effective Interest method and assuming the same facts as above except that the market rate of interest is 8.5%, prepare the journal entry for November 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Solution © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

© 2012 Cengage Learning. All Rights Reserved © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Retirement and Conversion of Bonds A company can reduce its bond debt by retiring the bonds or converting the bonds into common stock. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Retirement of Bonds (slide 1 of 3) Bond: On July 1, 2014 Zumi calls, or retires, at 105 the $200,000 of bonds it issued at a premium (104.1) on Jan 1, 2011.* The retirement thus takes place on the seventh interest payment date. Assume the entry for the required interest payment and the amortization of the premium has been made. * See slide 57 for the premium bond calculations. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Retirement of Bonds (slide 2 of 3) Analysis: The journal entry to record the retirement of bonds ▼ decreases the Bonds Payable account with a debit for the face amount to remove the bonds from the balance sheet, ▼ decreases the Unamortized Bond Premium account a debit (or credit to Unamortized Bond Discount) to remove the remaining related premium (or discount), ▼ decreases cash for the amount required to call the bonds, and ▲ increases loss (or gain) on Retirement of Bonds with a debit (or credit) for the net amount. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Retirement of Bonds (slide 3 of 3) Comment: In this entry, the cash paid is the face value times the call price ($200,000 × 1.05 = $210,000). The loss on retirement of bonds occurs because the call price of the bonds is greater than the carrying value ($210,000 –$202,892 = $7,108). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Conversion of Bonds (slide 1 of 3) Bond: Zumi’s bondholders* decide to convert all their bonds to $8 par value common stock under a convertible provision of 40 shares of common stock for each $1,000 bond. *See slide 57 for the premium bond calculations. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Conversion of Bonds (slide 2 of 3) Analysis: The journal entry to record the conversion of bonds to common stock ▼ decreases the Bonds Payable with a debit for the face amount to remove the bonds from the balance sheet, ▼ decreases the Unamortized Bond Premium account a debit (or the Unamortized Bond Discount with a credit )to remove the remaining related premium (or discount) from the records, ▲ increases the Common Stock account for the par value of the shares, and ▲ increases the Additional Paid-In Capital account for the amount required to balance the entry. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

EXAMPLE: Conversion of Bonds (slide 3 of 3) Comment: At a rate of 40 shares for each $1,000 bond, 8,000 shares will be issued, with a total par value of $64,000 (8,000 × $8). The Common Stock account is credited for the amount of the par value of the stock issued. In addition, Additional Paid-in Capital is credited for the difference between the carrying value of the bonds and the par value of the stock issued ($202,892 –$64,000 = $138,892). No gain or loss is recorded. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

Assume that Zumi Corporation is able to buy $200,000 in bonds on the open market at 95 and retire them. The Unamortized Bond Premium remains at $2,892. Prepare the entry to record the purchase and retirement on July 1, 2014. SOLUTION 2014 July 1 Bonds Payable 200,000 Unamortized Bond Premium 2,892 Gain on Retirement of Bonds 12,892 Cash 190,000 Retired 9% bonds at 95 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom