2. Ch 11: Long-Term Liabilities Notes, Bonds, and Leases
Long-term liabilities are recorded at the present value of the future cash flows.
Two components determine the “time value” of money:
interest (discount) rate
number of periods of discounting
Types of activities that require PV calculations:
notes payable
bonds payable and bond investments
capital leases

3. 1.Present Value of a Single Sum
All present value calculations presume a discount rate (i) and a number of periods of discounting (n). There are 3 different ways you can calculate the PV1:
1. Formula: PV1 = FV1 [1/(1+i)n]
2. Tables: See Page 684, Table 4
3.Calculator if it has time value of money functions.

4. Long-term Notes Payable
Problem 1: On January 2, 2008, 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?
PV1 = 50,000 ( ) = $37, [ i=6%, n=5]
Journal entry Jan. 2, 2008:
Dr. Land 37,363
Dr. Discount on N/P 12,637
Cr. Notes Payable 50,000

5. Problem 1 Solution, continued
The Effective Interest Method:
Interest Expense =
Carrying value x Interest rate x Time period
(CV) (Per year) (Portion of year)
Where carrying value = face - discount.
For Example 1, CV= 50, ,637 = 37,363
Interest expense = 37,363 x 6% per year x 1year
= $2,242

6. Problem 1 Solution, continued
Journal entry, December 31, 2008:
Carrying value on B/S at 12/31/2008?
(Discount = $12, ,242 = $10,395)
Interest expense 2,242
Discount on N/P 2,242
Notes Payable $50,000
Discount on N/P (10,395) $39,605

7. Problem 1 Solution, continued
Interest expense at Dec. 31, 2009:
39,605 x 6% x 1 = $2,376
Journal entry, December 31, 2009:
Carrying value on B/S at 12/31/2009?
(Discount = 10, ,376)
Carrying value on 12/31/2012 (before retirement)?
Interest expense 2,376
Discount on N/P 2,376
Notes Payable $50,000
Discount on N/P (8,019) $41,981
$50,000

8. 2. Present Value of an Ordinary Annuity(PVOA)
PVOA calculations presume a discount rate (i), where (A) = the amount of each annuity, and (n) = the number of annuities (or rents), which is the same as the number of periods of discounting. There are 3 different ways you can calculate PVOA:
1. Formula: PVOA = A [1-(1/(1+i)n)] / i
2. Tables: see page 685, Table 5
3.Calculator if it has time value of money functions.

9. Problem 2: Bonds Payable
On July 1, 2007, 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:
(1) What are the cash flows and factors?
Face value at maturity = $100,000
Stated Interest =
Face value x stated rate x time period
100,000 x 7% x (1/2) = $3,500
Number of periods = n = 5 years x 2 = 10
Discount rate = 6% / 2 = 3% per period

10. Problem 2 - calculations
PV of interest annuity:
PVOA Table PVOA Table
PVOA = A( ) = 3,500 ( ) = $29,856
i, n i = 3%, n = 10
PV of face value:
PV1 Table PV1 Table
PV =FV1( ) = 100,000 ( )=$74,409
i, n i=3%, n=10
Total issue price = $104,265
Issued at a premium of $4,265 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

11. Problem 2 - Amortization Schedule
To recognize interest expense using the effective interest method, an amortization schedule must be constructed. (This expands the text discussion.)
To calculate the columns (see next slide):
Cash paid = Face x Stated Rate x Time
= 100,000 x 7% x 1/2 year = $3,500
(this is the same amount every period)
Int. Expense = CV x Market Rate x Time
at 12/31/07 = 104,265 x 6% x 1/2 year = 3,128
at 6/30/08 = 103,893 x 6% x 1/2 year = 3,117
The difference between cash paid and interest expense is the periodic amortization of premium.
Note that the carrying value is amortized down to face value by maturity.

12. Problem 2 - Amortization Schedule
Cash Interest Carrying
Date Paid Expense Difference Value
7/01/ ,265
12/31/07 3, , ,893
6/30/08 3, , ,510
12/31/08 3, , ,115
6/30/09 3, , ,708
12/31/09 3, , ,289
6/30/10 3, , ,858
12/31/10 3, , ,414
6/30/11 3, , ,956
12/31/11 3, , ,485
6/30/12 3, , ,000

13. Problem 2 - Journal Entries
JE at 7/1/07 to issue the bonds:
JE at 12/31/07 to pay interest:
Note that the numbers for each interest payment come from the lines on the amortization schedule.
Cash ,265
Premium on B/P ,265
Bonds Payable ,000
Interest Expense ,128
Premium on B/P
Cash ,500

14. Bonds Payable at a Discount
If bonds are issued at a discount, the carrying value will be below face value at the date of issue.
The Discount on B/P account has a normal debit balance and is a contra to B/P (similar to the Discount on N/P).
The Discount account is amortized with a credit. Note that the difference between Cash Paid and Interest Expense is still the amount of amortization.
Interest expense for bonds issued at a discount will be greater than cash paid.
The amortization table will show the bonds amortized up to face value.

15. Problem 2 - Retirement of Bonds
Assume that Mustang’s bonds were retired on June 30, 2008 (after the interest payment). Mustang Corporation paid $104,000 to retire the bonds from the marketplace. Record the entries on June 30, 2008.
JE at 6/30/08 to pay the interest:
JE at 6/30/08 to retire the bonds:
Interest Expense 3,117
Premium on B/P
Cash ,500
Bonds Payable ,000
Premium on B/P 3,510
Loss on Retirement
Cash ,000

16. 3. PV of an Annuity Due (PVAD)
The difference between an ordinary annuity and an annuity due is the timing of the periodic payments: an annuity due has payments (rents, annuities) at the beginning of each period.
The result is that there is one less period of discounting.
There are 3 different ways you can calculate PVAD:
1. Formula: PVAD = A [((1-(1/(1+i)n-1)) / i) + 1]
2. Tables: see page 686, Table 6
PVAD Table
PVAD = A( )
i, n where n = number of payments (not periods)
3.Calculator if it has time value of money functions.

17. Leases
FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases.
Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability.
Requirements of SFAS No record as capital lease for the lessee if any one of the following is present in the lease:
Title transfers at the end of the lease period,
The lease contains a bargain purchase option,
The lease life is at least 75% of the useful life of the asset, or
The lessee pays for at least 90% of the fair market value of the lease.

18. Problem 3 - Leases
Lee Company (the lessee) signed a contract to lease equipment from Lawrence Company (the lessor). The terms of the lease were as follows:
1. Four year lease starting January 1, 2008.
2. Annual lease payments of $6,000. The first payment is due at lease inception (January 1, 2008), with subsequent payments on December 31, 2008, 2009, and 2010.
3. Bargain purchase option of $1,000 at end of lease (December 31, 2011).
Other information:
Lee’s borrowing rate: 8%
Useful life of equipment: 6 years with no salvage value.

19. Problem 3 - Leases PV1 Table PV1 Table
Requirement 1: Calculate the PVMLP
(Note that the lease payments are an annuity due.)
PVMLP = PV RENTS PVBPO
PVAD Table PVAD Table
PV RENTS =PVAD= A( ) = 6,000(3.5771) = $21,463
i, n i =8%, n=4
PV1 Table PV1 Table
PVBPO = PV1 = FV1( ) = 1,000( ) = $ 735
i, n i = 8%, n = 4
The present value of the minimum lease pmts = $22,198

20. Problem 3 - Leases Cash Interest Carrying
Date Paid Expense Difference Value
1/01/ ,198
1/01/08 6, , ,198
12/31/08 6, , , ,494
12/31/09 6, , ,414
12/31/10 6, ,
12/31/11 1,
1No interest at 1/1/08, because no time has passed. This is equivalent to a “down payment” which immediately reduces the total liability.
2Int. Expense = CV x MR x T = 16,198 x 8% x 1 year
3Rounding difference of $1 absorbed in calculation.

21. Problem 3 - Leases
Requirement 3: Prepare the following journal entries for the year 2008:
Initial lease at 1/1/08:
First payment at 1/1/08:
Second payment at 12/31/08:
Equipment ,198
Lease Liability ,198
Lease Liability ,000
Cash 6,000
Interest Expense ,296
Lease Liability ,704

22. Problem 3 - Leases
For the last entry, we must calculate straight-line depreciation on leased asset at 12/31/08.
Note that the calculation here is based on the length of time that the lessee will actually use the asset (6 years here because of the BPO).
(Cost-SV)/Est. life =(22, )/6 = $3,700
JE for Depreciation at 12/31/08:
Depreciation expense 3,700
Accumulated Depr ,700

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