Long-Term Liabilities Chapter 12 ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-1

Learning Objectives 1.Journalize transactions for long-term notes payable and mortgages payable 2.Describe bonds payable 3.Journalize transactions for bonds payable and interest expense using the straight- line amortization method ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-2

Learning Objectives 4.Journalize transactions to retire bonds payable 5.Report liabilities on the balance sheet 6.Use the debt to equity ratio to evaluate business performance ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-3

Learning Objectives 7.Use time value of money to compute the present value of future amounts (Appendix 12A) 8.Journalize transactions for bonds payable and interest expense using the effective- interest amortization method (Appendix 12B) ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-4

Learning Objective 1 Journalize transactions for long-term notes payable and mortgages payable ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-5

Long-Term Notes Payable Notes that do not need to be paid within one year or one operating cycle, whichever is longer.Notes that do not need to be paid within one year or one operating cycle, whichever is longer. –The portion due in the current year is reclassified as a current liability. Notes are recorded at the amount borrowed.Notes are recorded at the amount borrowed. Interest is not recorded until the end of the period.Interest is not recorded until the end of the period. Interest accruals are part of the adjusting process.Interest accruals are part of the adjusting process. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-6

Long-Term Notes Payable On December 31, 2014, Smart Touch Learning signed a $20,000 note payable. It is due in 4 annual payments of $5,000 plus 6% interest each December 31. Prepare the journal entry to record Smart Touch Learning’s note payable. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-7

Long-Term Notes Payable On December 31, 2014, Smart Touch Learning signed a $20,000 note payable. It is due in 4 annual payments of $5,000 plus 6% interest each December 31. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-8

Notes Payable Interest Interest on Notes Payable is computed as: The beginning balance will decline each period by the amount of the principal payment. Interest rates are always expressed as the rate for a whole year. This is the portion of a year that the interest period covers. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-9

Notes Payable Interest On December 31, 2014, Smart Touch Learning signed a $20,000 note payable. It is due in 4 annual payments of $5,000 plus 6% interest each December 31. Compute interest for ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-10

Notes Payable Interest On December 31, 2014, Smart Touch Learning signed a $20,000 note payable. It is due in 4 annual payments of $5,000 plus 6% interest each December 31. Compute interest for ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-11

Interest Amortization When a loan is taken out, an amortization schedule is prepared showing payments and interest over the term of the loan. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-12

Recording Interest Record the payment at December 31, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-13

Recording Interest Record the payment at December 31, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-14

On January 1, 2014, Fox Corporation signed an $80,000, four-year, 4% note. The loan required Fox to make payments annually on December 31 of $20,000 principal plus interest. Journalize the issuance of the note on January 1, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-15

On January 1, 2014, Fox Corporation signed an $80,000, four-year, 4% note. The loan required Fox to make payments annually on December 31 of $20,000 principal plus interest. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-16

On January 1, 2014, Fox Corporation signed an $80,000, four-year, 4% note. The loan required Fox to make payments annually on December 31 of $20,000 principal plus interest. Journalize the first payment on December 31, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-17

On January 1, 2014, Fox Corporation signed an $80,000, four-year, 4% note. The loan required Fox to make payments annually on December 31 of $20,000 principal plus interest. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-18

Learning Objective 2 Describe bonds payable ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-19

Bonds Long-term debt issued to multiple lenders.Long-term debt issued to multiple lenders. –Usually in $1,000 increments. Each bondholder gets a bond certificate.Each bondholder gets a bond certificate. TERMINOLOGY: Face valueFace value Interest rateInterest rate Issue dateIssue date Maturity dateMaturity date Payment termsPayment terms ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-20

©2014 Pearson Education, Inc. Publishing as Prentice Hall12-21

Types of Bonds Secured Bonds Backed by specific assets that have been pledged as collateral. Debentures (Unsecured Bonds) No collateral. Term Bond The bond principal is due in full at a single maturity date. Serial Bond The bond principal is repaid in installments over the maturity period. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-22

Bond Prices The face value of the bond defines how much principal will be paid at maturity.The face value of the bond defines how much principal will be paid at maturity. The bond selling price on the issue date will depend on:The bond selling price on the issue date will depend on: –The stated interest rate on the bond, and –The market rate of interest of similar bonds on the date of issue. Bond Issued at: Face value: stated rate = market rateFace value: stated rate = market rate Discount: stated rate < market rateDiscount: stated rate < market rate Premium: stated rate > market ratePremium: stated rate > market rate ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-23

Bond Prices ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-24

Determine whether the following bonds payable will be issued at face value, at a premium, or at a discount. A 10% bonds payable is issued when the market interest rate = 8%.A 10% bonds payable is issued when the market interest rate = 8%. A 10% bonds payable is issued when the market interest rate = 10%.A 10% bonds payable is issued when the market interest rate = 10%. A 10% bonds payable is issued when the market interest rate = 12%.A 10% bonds payable is issued when the market interest rate = 12%. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-25

Determine whether the following bonds payable will be issued at face value, at a premium, or at a discount. PREMIUMPREMIUM A 10% bonds payable is issued when the market interest rate = 10%.A 10% bonds payable is issued when the market interest rate = 10%. A 10% bonds payable is issued when the market interest rate = 12%.A 10% bonds payable is issued when the market interest rate = 12%. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-26

Determine whether the following bonds payable will be issued at face value, at a premium, or at a discount. PREMIUMPREMIUM FACE VALUEFACE VALUE A 10% bonds payable is issued when the market interest rate = 12%.A 10% bonds payable is issued when the market interest rate = 12%. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-27

Determine whether the following bonds payable will be issued at face value, at a premium, or at a discount. PREMIUMPREMIUM FACE VALUEFACE VALUE DISCOUNTDISCOUNT ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-28

Learning Objective 3 Journalize transactions for bonds payable and interest expense using the straight- line amortization method ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-29

Recording Bonds Payable at Face Value Smart Touch Learning has $100,000 of 9% bonds payable that mature in five years. The company issues the bonds on January 1, 2014 when the market rate is 9%. Journalize the issuance of the bonds on January 1, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-30

Recording Bonds Payable at Face Value Smart Touch Learning has $100,000 of 9% bonds payable that mature in five years. The company issues the bonds on January 1, 2014 when the market rate is 9%. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-31

Recording Bonds Issued at a Discount When the bond interest rate < the market rate, the bonds are issued at a discount. The difference between the bonds payable and the cash received is recorded as a Bond Discount (a contra- liability) –The discount is amortized over the life of the bond. Interest Expense each period will be the sum of the computed interest payment + the amortized portion of the discount. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-32

Recording Bonds Issued at a Discount Smart Touch Learning issues $100,000 of 9%, 5-year bonds that pay interest semiannually. The market rate of interest is 10%. Smart Touch Learning actually receives $96,149, and records a discount of $3,851. Journalize the issuance of the bonds on January 1, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-33

Recording Bonds Issued at a Discount Smart Touch Learning issues $100,000 of 9%, 5-year bonds that pay interest semiannually. The market rate of interest is 10%. Smart Touch Learning actually receives $96,149, and records a discount of $3,851. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-34

Straight-Line Amortization of the Discount ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-35

Straight-Line Amortization of the Discount Using the discount amortization table, record Smart Touch Learning’s first interest payment on June 30, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-36

Straight-Line Amortization of the Discount Using the discount amortization table, record Smart Touch Learning’s first interest payment on June 30, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-37

Learning Objective 4 Journalize transactions to retire bonds payable ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-38

Retirement at Maturity Smart Touch Learning has $100,000 of 9% bonds that mature on December 31, (Note that all interest has already been paid and the discount is fully amortized.) Record the retirement of the bonds at December 31, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-39

Retirement at Maturity Smart Touch Learning has $100,000 of 9% bonds that mature on December 31, (Note that all interest has already been paid and the discount is fully amortized.) ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-40

Retirement Before Maturity The full Bonds Payable will be retired.The full Bonds Payable will be retired. The cash paid will not equal the face value.The cash paid will not equal the face value. The remaining discount or premium will be removed.The remaining discount or premium will be removed. The difference will be recorded as either aThe difference will be recorded as either a –Gain on Retirement of Bonds –Loss on Retirement of Bonds ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-41

Retirement Before Maturity On December 31, 2014, Smart Touch Learning decides to retire its bonds by paying $95,000, after only two interest payments. The table indicates that the discount balance is now $3,081. Record the early retirement of the bonds at December 31, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-42

Retirement Before Maturity On December 31, 2014, Smart Touch Learning decides to retire its bonds by paying $95,000, after only two interest payments. The table indicates that the discount balance is now $3,081. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-43

Herrera Corporation issued a $400,000, 4.5%, 10-year bond payable on January 1, Journalize the retirement of the bond payable at maturity. Record the bond retirement and include the correct date. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-44

Smart Touch Learning issued a $400,000, 4.5%, 10-year bond payable on January 1, Journalize the retirement of the bond payable at maturity. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-45

Learning Objective 5 Report liabilities on the balance sheet ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-46

Reporting Liabilities Liabilities are grouped on the Balance Sheet as either Current or Long-Term.Liabilities are grouped on the Balance Sheet as either Current or Long-Term. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-47

Learning Objective 6 Use the debt to equity ratio to evaluate business performance ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-48

Debt to Equity Ratio Shows the proportion of total liabilities to total equity.Shows the proportion of total liabilities to total equity. A measure of “financial leverage.”A measure of “financial leverage.” A ratio > 1, the company is financing more assets with debt than with equity.A ratio > 1, the company is financing more assets with debt than with equity. –The higher the ratio, the more financial risk the company has. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-49

Debt to Equity Ratio The information below is from the 2011 Annual Report for Green Mountain Coffee Roasters, Inc. Calculate the Debt to Equity Ratio for ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-50

Debt to Equity Ratio ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-51

Compute the Debt to Equity Ratio for Payne Corporation for ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-52

Compute the Debt to Equity Ratio for Payne Corporation for ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-53

Learning Objective 7 Use time value of money to compute the present value of future amounts (Appendix 12A) ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-54

Time Value of Money Sometimes, we need to know how much an amount of money will grow if interest is applied for several years.Sometimes, we need to know how much an amount of money will grow if interest is applied for several years. A mathematical formula will allow us to make the calculation:A mathematical formula will allow us to make the calculation: ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-55

Time Value of Money If we invest $10,000 today at 6% interest and leave it for 5 years, how much will we have at the end of the period? ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-56

Time Value of Money If we invest $10,000 today at 6% interest and leave it for 5 years, how much will we have at the end of the period? ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-57

Present Value of a Lump Sum The formula can also be worked backward to determine today’s value of a future amount.The formula can also be worked backward to determine today’s value of a future amount. Simply use the inverse of the future value multiplier.Simply use the inverse of the future value multiplier. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-58

Present Value of a Lump Sum At 6% interest, how much would we need to invest today in order to have $13,382 in 5 years? ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-59

Present Value of a Lump Sum At 6% interest, how much would we need to invest today in order to have $13,382 in 5 years? ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-60

Present Value of an Annuity The total grows faster, if we also add a fixed amount each period to the original investment.The total grows faster, if we also add a fixed amount each period to the original investment. The present value of an annuity factor can be found in a table (see Appendix B in the text).The present value of an annuity factor can be found in a table (see Appendix B in the text). ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-61

Present Value of an Annuity What is the present day equivalent of an annuity of $2,000 per year for 5 years at 6%? ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-62

Present Value of an Annuity What is the present day equivalent of an annuity of $2,000 per year for 5 years at 6%? ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-63

Pricing Bonds Payable We can use the Present Value of a Lump Sum (PV) and the Present Value of an Annuity (PVA) concepts to determine the selling price of a bond.We can use the Present Value of a Lump Sum (PV) and the Present Value of an Annuity (PVA) concepts to determine the selling price of a bond. Bonds sell at the present value of all of the related cash flows:Bonds sell at the present value of all of the related cash flows: –The periodic interest payments. –The payout of principal at the end of the bond term. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-64

Pricing Bonds Payable Smart Touch Learning issues $100,000 of 5-year, 9% bonds that pay interest semi- annually. The market interest rate is 10%. –Maturity Payment = $100,000 –Periodic Interest = $4,500 –Interest rate = 5% (10% semiannually) –Number of periods = 10 (payments twice a year for 5 years) ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-65

Step 1: Present Value of the Principal This will be added to the present value of the interest payments.This will be added to the present value of the interest payments. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-66

Step 2: Present Value of the Interest Payments This will be added to the present value of the principal.This will be added to the present value of the principal. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-67

Step 3: Present Value of the Bond Payable This bond payable will sell at a discount of $3,851. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-68

Learning Objective 8 Journalize transactions for bonds payable and interest expense using the effective- interest amortization method (Appendix 12B) ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-69

Effective Interest Method for Interest Amortization Earlier we used a straight-line approach for amortizing the discount and determining interest expense.Earlier we used a straight-line approach for amortizing the discount and determining interest expense. The “effective interest method” computes interest expense based on the carrying amount of the bond, and “backs into” the discount amortization each period.The “effective interest method” computes interest expense based on the carrying amount of the bond, and “backs into” the discount amortization each period. ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-70

Effective Interest Method for Interest Amortization ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-71

Effective Interest Method for Interest Amortization Using the discount amortization table, record Smart Touch Learning’s first interest payment on June 30, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-72

Effective Interest Method for Interest Amortization Using the discount amortization table, record Smart Touch Learning’s first interest payment on June 30, ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-73

End of Chapter 12 ©2014 Pearson Education, Inc. Publishing as Prentice Hall12-74