1 Module 8: Liabilities

2 Long-term Notes Payable Usually issued to financial institutions. May be interest bearing or non-interest bearing (we will look at non-interest bearing). May be serial notes (periodic payments) or term notes (balloon payments). We will look at balloon payments here. Note: zero coupon bonds are similar in treatment to non-interest bearing notes. Illustration 1: On January, 2, 2005, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $50,000 at the end of the 5 year period. What is the cash equivalent price of the land, if a 6 percent discount rate is assumed?

3 Illustration1 Solution See page A2, Table 1 PV1 Table PV1 = FV1( ) i, n PV1 Table i=6%, n=5 Journal entry Jan. 2, 2005: Land37,363 Discount on N/P12,637 Notes Payable 50,000 PV1 = 50,000 ( ) = $37,363

4 Illustration1 Solution, continued Journal entry, December 31, 2005: Carrying value on B/S at 12/31/2005? (Discount = 12, ,242 = 10,395) Interest expense2,242 Discount on N/P 2,242 Notes Payable$50,000 Discount on N/P (10,395) $39,605

5 Illustration 1 Solution, continued Interest expense at Dec. 31, 2006: 39,605 x.06 x 1 = $2,376 Journal entry, December 31, 2006: Carrying value on B/S at 12/31/2006? (Disc.=10,395-2,376) Carrying value on 12/31/2009 (before retirement)? $50,000 Interest expense2,376 Discount on N/P 2,376 Notes Payable$50,000 Discount on N/P (8,019) $41,981

6 Illustration 2: Bonds Payable On July 1, 2005, 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 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

7 Illustration 2 - Journal Entries JE at 7/1/05 to issue the bonds: JE at 12/31/05 to pay interest: Note that the numbers for each interest payment come from the lines on the amortization schedule. Cash 104,265 Premium on B/P 4,265 Bonds Payable 100,000 Interest Expense 3,128 Premium on B/P 372 Cash 3,500

8 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 to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = (2) Stated Interest = Face value x stated rate x time period Number of periods = n = 5 yrs Discount rate = 6% per year $100, ,000 x.05 per yr x 1 yr. = $5,000

9 Illustration 3 : Present Value Calculations PV of interest annuity: PVOA Table PVOA Table PVOA=A( ) = i, n i = 6%, n=5 PV of face value: PV1 Table PV1 Table PV =FV1( ) = i, n I = 6%, n=5 Total issue price = Issued at a discount of $4,212 because the company was offering an interest rate less than the market rate, and investors were not willing to pay as much for the lower interest rate. 5,000 ( ) = $21, ,000( )=$74,726 $95,788

10 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 (the carrying value is 95,788) Cash 95,788 Discount on B/P 4,212 Bonds Payable 100, ,000 (4,212) 95,788

11 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 Interest expense = CV x market rate x time = = 95,788 x.06 x 1 yr = $5,747 (rounded) Amortization of discount = difference (plug) = 5,747 – 5,000 = 747 (credit) Now journal entry: Interest Expense 5,747 Discount on B/P 747 Cash 5,000