1. Accounting for Long-Term Notes Payable and Bond Liabilities
Chapter Ten
Accounting for Long-Term Notes Payable and Bond Liabilities
In Chapter Ten, we will learn about two types of long-term debt: notes payable and bonds payable. We will examine issuing bonds at face value, at a discount, and at a premium.

2. Learning Objective 1
Show how the amortization of long-term notes affects financial statements.
Learning Objective One:
Show how the amortization of long-term notes affects financial statements.

3. Installment Notes Payable
Long-term installment notes are liabilities that usually have terms from two to five years.
Principal
Payments
Company
Lender
Part One
Long-term installment notes are liabilities that usually have terms from two to five years.
Part Two
The principal balance is repaid with a series of equal payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up with installment payments.
Part Three
For each payment that is made, the amount applied to the principal increases and the amount of the interest decreases.
Each payment covers interest for the period and a portion of the principal.
With each payment, the interest portion gets smaller and the principal portion gets larger.

4. Installment Notes Payable
Applying payments to principal and interest
Identify the unpaid principal balance.
Amount applied to interest = Unpaid principal balance × Interest rate.
Amount applied to principal = Cash payment – amount applied to interest in .
Unpaid principal balance = Unpaid principal balance in  – amount applied to principal in .
To determine the portion of each payment that is interest and the portion to apply to the principal, follow these four steps:
 Identify the unpaid principal balance.
 Multiply the unpaid principal balance times the interest rate to find the portion of the payment that is interest.
 Subtract the portion of the payment that is interest in  from the total cash payment to find the portion of the payment to apply to the principal.
 The updated unpaid principal balance equals the unpaid principal balance in  minus the portion of the payment applied to the principal in .
Let’s look at an example.

5. Prepare an amortization table for Mason’s note.
Installment Notes Payable
On January 1, 2005, Mason Company issued a $100,000 face value installment note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year.
Prepare an amortization table for Mason’s note.
Take a minute and review this information for Mason Company. On January 1st, 2005, Mason Company borrowed one hundred thousand dollars from National Bank. The loan has a nine percent interest rate and will be repaid with five annual payments of twenty-five thousand seven hundred nine dollars each.
Let’s look at the amortization table for this loan.

6. Installment Notes Payable
Cash payment determined using present value concepts presented in Chapter 10 appendix.
Notice that the annual payment is always twenty-five thousand seven hundred nine dollars. Also notice that for each payment the interest portion decreases and the principal portion increases.
Let’s review how to get the amount applied to interest and the amount applied to principal for the first payment on this note.
The interest portion is calculated by multiplying the one hundred thousand dollar unpaid balance at the beginning of the period times nine percent to get nine thousand dollars.
The principal portion is calculated by subtracting nine thousand dollars from twenty-five thousand seven hundred nine dollars to get sixteen thousand seven hundred nine dollars.
You should verify the remaining computations in the amortization table before advancing.
All computations rounded to the nearest dollar.

7. Annual payments are constant.
Installment Notes Payable
Annual payments are constant.
The graph on your screen shows that the amount of each payment applied to the principal increases each year, while the amount of interest decreases each year.
The amount applied to the principal increases each year. The amount of interest decreases each year.

8. Installment Notes Payable
Issuing the note has the following effect on Mason’s 2005 financial statements:
The December 2005 cash payment has the following effect on Mason’s 2005 financial statements:
Part One
Issuing the note payable increases both assets (Cash) and liabilities (Notes Payable). There is no effect on the Income Statement when the note is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows.
Part Two
Each payment decreases assets (Cash) by the amount of the payment. Liabilities (Notes Payable) decrease by the amount of the payment applied to principal. Equity (Retained Earnings) decreases by the amount of the payment that is interest. Net income decreases by the amount of interest. The portion of the payment that is interest is reported in the operating section of the Statement of Cash Flows. The portion of the payment applied to principal is reported in the financing section of the Statement of Cash Flows.

9. Installment Notes Payable
Although the amounts for interest expense and principal repayment differ each year, the effects of the annual payment on the financial statements are the same.
On the balance sheet, assets (cash) decrease by the total amount of the payment; liabilities (notes payable) decrease by the amount of the principal repayment; and stockholders’ equity (retained earnings) decreases by the amount of interest expense.
Net income decreases from recognizing interest expense. On the statement of cash flows, the portion of the cash payment applied to interest is reported in the operating activities section and the portion applied to principal is reported in the financing activities section.

10. Learning Objective 2
Show how a line of credit affects financial statements.
Learning Objective Two:
Show how a line of credit affects financial statements.

11. Line of Credit
Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up to the maximum credit line set by the creditor.
Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs.
Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up to the maximum credit line set by the creditor. Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs.
For an individual, overdraft protection on a checking account is similar to a business line of credit.

12. Line of Credit
Lagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales.
Lagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales. Each borrowing is an asset source transaction (cash and the line of credit liability increase). Each repayment is an asset use transaction (cash and retained earnings decrease as does net income).
Each borrowing is an asset source transaction. Each repayment is an asset use transaction.

13. Effects on Financial Statements
Study the effects on the financial statements that result from each of the borrowings and repayments on the line of credit.

14. Learning Objective 3
Describe the different types of bonds that companies issue.
Learning Objective Three:
Describe the different types of bonds that companies issue.

15. Significant debt needs of a company are often filled by issuing bonds.
Bond Liabilities
Significant debt needs of a company are often filled by issuing bonds.
Bonds
Cash
When a company has a relatively small need for cash, the need can usually be met by a single lender, such as a bank. However, when a company needs large amounts of cash, one creditor may not be able to loan the amount required, or may not be willing to take on all the risk of such a large loan. So, in this case, many companies issue bonds to lots of different people and institutions to acquire the needed funds.

16. Bond Liabilities
Bonds involve the long-term borrowing of a large sum of money, called the principal.
The principal is usually paid back as a lump sum at maturity.
Individual bonds are often denominated with a face value of $1,000.
When companies need large amounts of cash for longer periods of time, they often issue bonds. The principal on bonds is typically paid at the end of the bond period. Each bond in the total bond issue is usually denominated with a face value of one thousand dollars.

17. Bond Liabilities
Bonds usually have periodic interest payments based on a stated rate of interest.
Interest is normally paid semiannually.
Interest paid is computed as:
Interest = Principal × Stated Rate × Time
Bond prices are usually quoted as a percentage of the face amount.
For example, a $1,000 bond priced at 104 would sell for $1,040.
Bonds normally have an interest rate that is called a stated rate. Interest is normally paid semiannually and is computed as Principal times Rate times Time. This computation should look familiar to you.
Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their face value.

18. Bond Liabilities Bond Certificate at Face Value Corporation Investors
Bond Selling Price
Bond Certificate
at Face Value
Corporation
Investors
On the issue date, the bondholders give the company the market value, or selling price of the bond issue. The company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date.
Bond Issue Date

19. Bond Liabilities Corporation Investors Bond Interest Payments
At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as bond face value times the stated interest rate on the bond times the time the bond has been outstanding during the year.
Interest Payment =
Principal × Interest Rate × Time
Bond Issue Date

20. Bond Liabilities Corporation Investors Bond Maturity Date
Bond Principal
at Maturity Date
Corporation
Investors
At the maturity date, the company pays the bondholders the bond’s face value.
Bond Maturity Date
Bond Issue Date

21. Bond Liabilities Advantages of bonds
Bonds usually have longer terms to maturity than notes payable issued to banks.
Bond interest rates are usually lower than bank loan rates.
Bonds offer advantages for the issuing company. They usually have longer terms to maturity than notes payable issued to banks, often twenty or thirty years. In addition, bond interest rates are usually lower than bank loan rates.

22. Characteristics of Bonds
Term and Serial
Secured and Unsecured
Convertible and Callable
There are several common types of bonds.
Secured bonds, sometimes called mortgage bonds, have specific assets of the issuer pledged as collateral. Unsecured bonds, sometimes called debentures, are backed by the issuer’s general credit standing.
Term bonds are scheduled for maturity on one specified date. Serial bonds mature at more than one date.
Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.

23. Learning Objective 4
Show how bond liabilities and their related interest costs affect financial statements.
Learning Objective Four:
Show how bond liabilities and their related interest costs affect financial statements.

24. Learning Objective 5
Explain how to account for bonds and their related interest costs.
Learning Objective Five:
Explain how to account for bonds and their related interest costs.

25. Bonds Issued at Face Value
Mason Company issues bonds on January 1, 2001.
Principal = $100,000
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2005 (5 years)
Mason Company issues bonds at face value. This means that the stated interest rate on the bond and the market interest rate on the bond are equal. Mason’s bonds have a face value of one hundred thousand dollars, a stated interest rate of nine percent with interest payable on December 31st of each year. The bonds are issued on January 1st, 2001, and mature five years later on December 31st, 2005.
On the issue date, the bondholders give Mason Company the selling price of the bond issue, and Mason Company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date.
Bond Selling Price
Bond Certificate
at Face Value
Mason Company
Investors

26. Bonds Issued at Face Value
Event 1 Issue Bonds for Cash
Issuing the bonds has the following effect on Mason’s 2001 financial statements:
To record the bond issue, Mason Company would make the following entry on January 1, 2001:
Part One
Issuing the bond payable increases both assets (Cash) and liabilities (Bonds Payable). There is no effect on the income statement when the note is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows.
Part Two
On the issue date, Mason Company would debit Cash and credit Bonds Payable for one hundred thousand dollars. The Bonds Payable account is always credited for the face value, or maturity value, of the bonds.

27. Bonds Issued at Face Value
Event 2 Investment in Land
Paying $100,000 cash to purchase land is an asset exchange transaction.
Event 3 Revenue Recognition
Recognizing $12,000 cash revenue from renting the property is an asset source transaction.
Part One
The asset cash decreases and the asset land increases by one hundred thousand dollars. There is no effect on the income statement. The cash outflow is reported in the investing section of the Statement of Cash Flows.
Part Two
This event is repeated each year from 2001 through The asset cash increases by twelve thousand dollars as does the equity account, retained earnings. Recognizing revenue increases net income. The cash inflow is reported in the operating activities section of the statement of cash flows.

28. Bonds Issued at Face Value
On each interest payment date, Mason Company will pay $9,000 in interest. The amount is computed as follows:
$100, 000 × 9% = $9,000
On each interest payment date for the five-year term of the bond issue, Mason will pay the bondholders a total of nine thousand dollars in interest. The interest is calculated by multiplying one hundred thousand dollars times the nine percent annual interest rate.
Bond Interest Payments
Mason Company
Investors

29. Bonds Issued at Face Value
Event 4 Expense Recognition
Mason’s $9,000 ($100,000 x 0.09) cash payments represent interest expense.
To record an interest payment, Mason Company would make the following entry on each December 31:
Part One
This event is also repeated each year from 2001 through Each interest payment decreases assets (Cash) and decreases Equity (Retained Earnings) by the amount of the interest payment. Net income also decreases by the amount of the interest payment. The interest payment is reported in the operating section of the Statement of Cash Flows.
Part Two
On each interest payment date for the five-year term of the bond issue, Mason will debit Bond Interest Expense and credit Cash for nine thousand dollars.

30. Bonds Issued at Face Value
Event 5 Sale of Investment in Land
Selling the land for cash equal to its $100,000 book value is an asset exchange transaction.
Cash increases and land decreases. Since there is no gain or loss on the sale, the income statement is not affected. The cash inflow is reported in the investing activities section of the statement of cash flows.

31. Bonds Issued at Face Value
On December 31, 2005, Mason Company will return the $100,000 principal amount to the investors.
On the maturity date, Mason Company will pay the bondholders one hundred thousand dollars, the face amount of the bonds. At this time, the debt is extinguished.
Bond Principal
at Maturity Date
Mason Company
Investors

32. Bonds Issued at Face Value
Event 6 Payoff of Bond Liability
The principal repayment on December 31, 2005 will have the following effect on Mason’s 2005 financial statements:
To record the principal repayment, Mason Company would make the following entry on December 31, 2005:
Part One
The repayment at maturity decreases assets (Cash) and decreases liabilities (Bonds Payable) by one hundred thousand dollars. Net income is not affected by the repayment. The repayment is reported in the financing section of the Statement of Cash Flows.
Part Two
On the maturity date, Mason Company will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for one hundred thousand dollars.

33. Bonds Issued at Face Value
Compare Blair Company’s income statement in Exhibit ten dash two with Mason Company’s income statement in this exhibit.

34. Bonds Issued at a Discount
If bonds of other companies are yielding more than 9%, investors will be unwilling to pay the full face amount for Mason’s 9% bonds. The issue price of Mason’s 9% bonds will have to be lower to entice investor interest. The difference between the lower issue price and the principal of $100,000 is called a discount.
Let’s continue the Mason Company example.
In almost all cases, the stated rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. The bond certificate lists all of the specifics about the bond including the stated interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate.
The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue.
For example, if the market rate of interest is more than nine percent, investors will be unwilling to pay the full face amount of one hundred thousand dollars for Mason’s nine percent bonds. The issue price of Mason’s nine percent bonds will have to be lower to entice investor interest. The difference between the lower issue price and the face amount of one hundred thousand dollars is called a discount.
Let’s continue the Mason Company example.

35. Bonds Issued at a Discount
Mason Company issues bonds on January 1, 2001.
Principal = $100,000
Issue price = $95,000
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2005 (5 years)
The only change from previous Mason example.
Because the market rate of interest is more than nine percent, Mason must reduce the issue price of its nine percent bonds from one hundred thousand dollars to ninety-five thousand dollars to attract investors. The difference between the one hundred thousand dollar face value of the bonds and the cash issue price of ninety-five thousand dollars is the five thousand dollar discount that Mason offers to the bond investors.

36. Bonds Issued at a Discount
Event 1 Issue Bonds for Cash
Bonds with a face value of $100,000 are issued at 95.
To record the bond issue, Mason Company would make the following entry on January 1, 2001:
Part One
Issuing the bonds at a discount increases assets (Cash) by ninety-five thousand dollars. Liabilities (Bonds Payable) are increased by one hundred thousand dollars less the Bond Discount that is increased by five thousand dollars. There is no effect on the Income Statement when the bonds are issued. The cash inflow is reported in the financing section of the Statement of Cash Flows.
Part Two
On the issue date, Mason will debit Cash for the ninety-five thousand dollars of cash received, credit Bonds Payable for the face amount of one hundred thousand dollars, and debit Discount on Bonds Payable for the five thousand dollar difference.
Discount on Bonds Payable is a contra-liability account and has a normal debit balance.

37. Bonds Issued at a Discount
Carrying Value
On the balance sheet, the discount account is subtracted from the face value of the bonds to arrive at the current carrying value of the bonds.
Maturity Value

38. Bonds Issued at a Discount
Amortizing the discount over the term of the bond increases Interest Expense each interest payment period.
Using the straight-line method, the discount amortization will be $1,000 every year.
$5,000 ÷ 5 years = $1,000
The discount represents an additional interest factor that will be amortized to Interest Expense over the life of the bond. Amortizing the discount will increase the total Interest Expense recorded for the bond each interest payment period.
Using the straight-line method to amortize the discount, Mason Company will divide the total discount by the number of interest payment periods to get the amount of the discount amortized each interest payment period. Since this is a five-year bond and it pays interest annually, there are five interest payment periods. This calculation determines that the discount amortization will be one thousand dollars at each interest payment date.

39. Bonds Issued at a Discount
The December 31, 2001 interest payment (and all other annual interest payments) has the following effect on Mason’s financial statements:
To record an interest payment, Mason Company would make the following entry on each December 31:
Part One
Each interest payment decreases assets (Cash) by nine thousand dollars cash paid and reduces the Discount on Bonds Payable by one thousand dollars. Equity (Retained Earnings) is reduced by the total Interest Expense of ten thousand dollars. Net income also decreases by the total amount of Interest Expense. The nine thousand dollar cash interest payment is reported in the operating section of the Statement of Cash Flows.
Part Two
Every year, Mason Company will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The credit to Discount on Bonds Payable is determined using the straight-line method we discussed on the previous slide. The debit to Bond Interest Expense is the total of the two credit amounts in this entry.

40. Bonds Issued at a Discount
$5,000 – $1,000
Maturity Value
Carrying Value
On the balance sheet, the discount account is subtracted from the par value of the bonds to arrive at the current carrying value of the bonds. As the discount is amortized, the carrying value will increase to exactly one hundred thousand dollars on the maturity date.
The carrying value will increase to exactly $100,000 on the maturity date.

41. Bonds Issued at a Discount
The principal repayment on December 31, 2005 will have the following effect on Mason’s 2005 financial statements:
To record the principal repayment, Mason Company would make the following entry on December 31, 2005:
Part One
The repayment at maturity decreases assets (Cash) and decreases liabilities (Bonds Payable) by one hundred thousand dollars. Net income is not affected by the repayment. The ninety-five thousand dollars of the repayment is reported in the financing section of the Statement of Cash Flows; the remaining five thousand dollars is reported in the operating section.
Part Two
On the maturity date, Mason Company will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for one hundred thousand dollars.

42. Bonds Issued at a Discount
The net income reported here differs from the net income reported when the bonds sold at face value. Two factors cause this: lower revenues (because less desirable land was bought) and higher interest expense.
On the balance sheet, the carrying value of the bond liability increases each year until the maturity date when it is equal to the one hundred thousand dollar face value of the bonds.
Compare this statement of cash flows with the earlier one where the bonds were issued at face value. There are several significant timing differences between when the interest expense is recognized and when the cash outflows occur.

43. Bonds Issued at a Premium
If bonds of other companies are yielding less than 9%, investors will be willing to pay more than the face amount for Mason’s 9% bonds. The issue price of Mason’s 9% bonds will rise because of investor demand for the 9 percent bonds. The difference between the higher issue price and the principal of $100,000 is called a premium.
Let’s continue the Mason Company example.
Remember that in almost all cases, the stated rate and the market rate of interest will not agree. When this happens, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue.
For example, if the market rate of interest is less than nine percent, investors will be willing to pay more than the full face amount of one hundred thousand dollars for Mason’s nine percent bonds. The issue price of Mason’s nine percent bonds will rise because of investor demand for the nine percent bonds. The difference between the higher issue price and the face amount of one hundred thousand dollars is called a premium.
Let’s continue the Mason Company example.

44. Bonds Issued at a Premium
Mason Company issues bonds on January 1, 2001.
Principal = $100,000
Issue price = $105,000
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2005 (5 years)
The only change from previous Mason example.
Because the market rate of interest is less than nine percent, Mason will increase the issue price of its nine percent bonds from one hundred thousand dollars to one hundred five thousand dollars. The difference between the one hundred thousand dollar face value of the bonds and the cash issue price of one hundred five thousand dollars is the five thousand dollar premium.

45. Bonds Issued at a Premium
Issuing the bonds at a premium has the following effect on Mason’s 2001 financial statements:
To record the bond issue, Mason Company would make the following entry on January 1, 2001:
Part One
Issuing the bonds at a premium increases assets (Cash) by one hundred five thousand dollars. Liabilities (Bonds Payable) are increased by one hundred thousand dollars plus the Bond Premium that is increased by five thousand dollars. There is no effect on the income statement when the bonds are issued. The cash inflow is reported in the financing section of the Statement of Cash Flows.
Part Two
On the issue date, Mason will debit Cash for the one hundred five thousand dollars of cash received, credit Bonds Payable for the face amount of one hundred thousand dollars, and credit Premium on Bonds Payable for the five thousand dollar difference.
Premium on Bonds Payable is an adjunct-liability account and has a normal credit balance.

46. Bonds Issued at a Premium
Maturity Value
Carrying Value
On the balance sheet, the premium is added to the face value of the bonds to arrive at the current carrying value of the bonds.

47. Bonds Issued at a Premium
Amortizing the premium over the term of the bond decreases Interest Expense each interest payment period.
Using the straight-line method, the premium amortization will be $1,000 every year.
$5,000 ÷ 5 years = $1,000
The premium represents a reduction in interest that will be amortized to Interest Expense over the life of the bond. Amortizing the premium will decrease the total Interest Expense recorded for the bond each interest payment period.
Using the straight-line method to amortize the premium, Mason Company will divide the total premium by the number of interest payment periods to get the amount of the premium amortized each interest payment period. Since this is a five-year bond and it pays interest annually, there are five interest payment periods. This calculation determines that the premium amortization will be one thousand dollars at each interest payment date.

48. Bonds Issued at a Premium
The December 31, 2001 interest payment (and all other annual interest payments) has the following effect on Mason’s financial statements:
To record an interest payment, Mason Company would make the following entry on each December 31:
Part One
Each interest payment decreases assets (Cash) by nine thousand dollars cash paid and reduces the Premium on Bonds Payable by one thousand dollars. Equity (Retained Earnings) is reduced by eight thousand dollars of Interest Expense, which is the difference between the cash interest payment and the amount of premium amortization. Net income also decreases by the total amount of Interest Expense. The nine thousand dollar cash interest payment is reported in the operating section of the Statement of Cash Flows.
Part Two
Every year, Mason Company will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The debit to Premium on Bonds Payable is determined using the straight-line method we discussed on the previous slide. The debit to Interest Expense is the difference between the nine thousand dollars of cash paid and the one thousand dollars of premium amortization.

49. Bonds Issued at a Premium
$5,000 – $1,000
Maturity Value
Carrying Value
On the balance sheet, the premium account is added to the face value of the bonds to arrive at the current carrying value of the bonds. As the premium is amortized, the carrying value will decrease to exactly one hundred thousand dollars on the maturity date.
The carrying value will decrease to exactly $100,000 on the maturity date.

50. Bonds Issued at a Premium
The principal repayment on December 31, 2005 will have the following effect on Mason’s 2005 financial statements:
To record the principal repayment, Mason Company would make the following entry on December 31, 2005:
Part One
The repayment at maturity decreases assets (Cash) and decreases liabilities (Bonds Payable) by one hundred thousand dollars. Net income is not affected by the repayment. The repayment is reported in the financing section of the Statement of Cash Flows.
Part Two
On the maturity date, Mason Company will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for one hundred thousand dollars.

51. Learning Objective 6
Explain why bonds are issued at face value, a discount, or a premium.
Learning Objective Six:
Explain why bonds are issued at face value, a discount, or a premium.

52. The Market Rate of Interest
The selling price of a bond is determined by the market rate of interest versus the stated rate of interest. = =
The issue price of a bond is determined by comparing the market interest rate with the stated interest rate on the bond.
If the stated interest rate on the bond is equal to the market interest rate, then the bond issue sells at face value.
If the stated interest rate on the bond is less than the market interest rate, then the bond issue sells at a discount.
If the stated interest rate on the bond is greater than the market interest rate, then the bond issue sells at a premium.
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53. Bond Redemptions
Companies may redeem bonds with a call provision prior to the maturity date.
Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement.
Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity. The call provision usually requires the issuer to pay a call premium to retire the bonds.
If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bonds. Gains or losses due to bond retirement should be reported as other income or other expense on the income statement.

54. Bond Redemptions
On January 1, 2004, three years after issue, Mason Company redeems its 9% bonds that were sold at a discount. The bonds have a call provision requiring Mason to pay a call price of $1,030 for each $1,000 bond. On the call date, the bonds have a carrying value of $98,000.
Part One
On January 1st, 2004, three years after issue, Mason Company redeems its nine percent bonds that were sold at a discount. The bonds have a call provision requiring Mason to pay a call price of one thousand thirty dollars for each one thousand dollar bond. On the call date, the bonds have a carrying value of ninety-eight thousand dollars (one hundred thousand dollar face value minus two thousand dollar remaining discount).
Part Two
The five thousand dollar loss on redemption is equal to the total amount paid, one hundred three thousand dollars, minus the carrying value of ninety-eight thousand dollars.

55. Bond Redemptions
The bond redemption on January 1, 2004, will have the following effect on Mason’s 2004 financial statements:
To record the bond redemption, Mason Company would make the following entry on January 1, 2004:
Part One
The bond redemption on January 1st, 2004, decreases assets (Cash) by one hundred three thousand dollars and decreases liabilities (Bonds Payable) by one hundred thousand dollars. Bond Discount is also reduced by the two thousand dollars of unamortized discount. Net income is reduced by the five thousand dollar loss. The one hundred three thousand dollars cash payment is reported in the financing section of the Statement of Cash Flows.
Part Two
On January 1st, 2004, Mason Company will record the redemption by debiting Bonds Payable for one hundred thousand dollars, debiting Loss on Bond Redemption for five thousand dollars, crediting Discount on Bonds Payable for five thousand dollars, and crediting Cash for one hundred three thousand dollars.

56. Learning Objective 7
Explain the advantages and disadvantages of debt financing.
Learning Objective Seven:
Explain the advantages and disadvantages of debt financing.

57. Security for Bank Loan Agreements
To reduce the risk that they will not be repaid, lenders often:
Require debtors to pledge collateral to secure the loan
Include covenants in the loan agreement restricting:
Additional borrowing
Dividends
Salary increases
To reduce the risk that they will not be paid, creditors frequently require debtors to pledge designated assets as collateral for loans. You may have experienced this when purchasing a car if the financing institution retained title to your car until all payments were made.
In addition to requiring collateral from companies borrowing money, banks often include covenants in loan agreements that restrict additional borrowing, dividend payments to owners, and salary increases.

58. Financial Leverage and Tax Advantage of Debt Financing
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. Consider the following example with $100,000 of debt financing.
Part One
An additional advantage of debt financing is financial leverage. Debt financing can increase retained earnings more than equity financing if the borrower is able to earn more on the borrowed funds than is paid in interest. Let’s look at an example.
Part Two
In the example on your screen, income of twenty thousand dollars is the same in both situations. But debt financing produces two thousand four hundred dollars more retained earnings than equity financing. If equity financing is obtained, the company pays six thousand dollars in income taxes; debt financing requires only three thousand six hundred dollars of income taxes.
However, this is a warning as not all debt financing produces a greater increase retained earnings. Financial leverage can have the opposite effect if the borrower earns less on the borrowed funds than is paid in interest.

59. Times Interest Earned Ratio
Numerator is commonly called EBIT, Earnings before interest and taxes.
Net income + Interest expense + Income tax expense
Interest expense
Times Interest Earned =
Long-term creditors are particularly interested in the ability of a company to meet periodic interest payments. Times interest earned is a ratio that is important to creditors. The ratio is calculated by dividing earnings before interest and taxes by interest expense for the period.
The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio.
The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio.

60. Learning Objective 8 Explain the time value of money. (Appendix)
Learning Objective Eight:
Explain the time value of money. (Appendix)

61. Time Value of Money-Terms
Simple interest -Interest computed by multiplying the principal by the interest rate by the number of periods.
Compound interest - Practice of reinvesting interest so that interest is earned on interest as well as on the initial principal.
Simple interest – Interest computed by multiplying the principal by the interest rate by the number of periods. Interest earned in a period is not added to the principal, so that no interest is earned on the interest of previous periods.
Compound interest – Practice of reinvesting interest so that interest is earned on interest as well as on the initial principal.

62. Time Value of Money-Terms
Future Value – Amount an investment will be worth at some point in the future, assuming a specified interest rate and the reinvestment of interest each period that it is earned.
Present Value – Current value of some investment amount that is expected to be received at some specified future time.
Future Value – Amount an investment will be worth at some point in the future, assuming a specified interest rate and the reinvestment of interest each period that it is earned.
Present Value – Current value of some investment amount that is expected to be received at some specified future time.

63. Time Value of Money-Terms
Annuity – Series of equal payments made over a specified number of periods.
Annuity – Series of equal payments made over a specified number of periods.

64. End of Chapter Ten
In this chapter, we learned about two types of long-term debt: notes payable and bonds payable. We examined issuing bonds at face value, at a discount, and at a premium.