1. Liabilities: Introduction
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Liabilities: Introduction

2. Objectives of the Chapter
To learn the basic concepts of liabilities and liability recognition.
To learn accounting for current liabilities, including estimated and contingent liabilities.
To learn accounting for long-term liabilities (i.e., issuance of bonds for cash).
Liabilities: Introduction

3. Objectives of the Chapter (contd.)
To study the accounting procedures for interest payments of bonds and the amortization of bond discount or premium.
To study the accounting procedures for debt retirements either at or before maturity.
To learn the accounting for issuance of long-term note for assets or cash.
Liabilities: Introduction

4. Liabilities: Introduction
Legal obligations require future payments of cash or services or the creation of other liabilities as a result of past transactions.
Recognition principle: accrual basis (i.e., A liability should be recognized when it occurs, not when it is paid.)
Liabilities: Introduction

5. The Importance of Understanding the GAAP’s Definition of a Liability
Lenders often require the borrowers to keep debt/equity under a specific level (i.e., not more than 50%) in the loan agreement.
If the ratio is greater than the constraint, the lender may have additional rights, such as to charge a higher interest rate.
Investors (creditors) often use the debt/equity ratio to make their credit decisions.
Liabilities: Introduction

6. Off-Balance Sheet Liabilities
When calculating the debt/equity ratio, attention should be given to the off-balance sheet liabilities which are obligations not reported as liabilities on the balance sheet and only disclosed in the footnotes.
Examples: operating lease obligations, pension liabilities, SPE’s liabilities guaranteed by the corporation/sponsor, etc.
Off-balance liabilities will be discussed in chapter 10.
Liabilities: Introduction

7. Liabilities: Introduction
2. Current Liabilities
Obligations must be fulfilled in one year or one operating cycle, whichever is longer.
Examples of current liabilities as a result of a business transaction: (with definite amount)
A/P (accounts payable)
N/P (notes payable)
Current maturity portion of a long-term debt (i.e., bonds payable)
Sales taxes payable
Payroll taxes withholdings
Liabilities: Introduction

8. Liabilities: Introduction
Employee Related Liabilities: FICA, Federal I/T, state I/T, Medical Insurance Premiums…
i.e.
Salaries Expense 50,000
Employee F.I.C.A. Taxes Payable* 3,825
Federal I/T Payable 10,000
State I/T Payable 2,500
Salaries Payable 32,675
* * 50,000
Liabilities: Introduction

9. Employee Related Liabilities (contd.)
Employer payroll taxes:
Payroll Taxes Expense 6,925
Employer F.I.C.A. Taxes Payable 3,825
F.U.T.A. Taxes Payablea 400
State Unemployment Tax Payableb 2,700
a. 6.2% of the first $7,000 of salaries paid to employees.
b. assuming a state unemployment tax = 5.4%.
Liabilities: Introduction

10. Other Current Liabilities (with definite amount)
Refundable Deposits
Cash xxx
Refund Deposit Liabilities xxx
Unearned Revenue (i.e., subscription fees received in advance, advances from customers before delivery, etc.)
Cash xxx
Unearned Subscription Revenue xxx (or Advances from Customers)
Liabilities: Introduction

11. Liabilities: Introduction
Accrued Liabilities
Obligations accumulated on a daily basis but not recorded until the end of period through adjusting entries (i.e., Interest payable, salaries payable, rent payable…)
J. E. Interest Expense xxx
Interest Payable xxx
Liabilities: Introduction

12. Estimated Liabilities
Liabilities exist but the amount is unknown, i.e.,
Property taxes
Warranty obligations
Coupon and premium obligations
Vacation Wage and Fringes Payable
Liabilities: Introduction

13. Expense Warranty Using Accrued Method
(for financial Reporting Purposes)
Estimate the warranty expense associated with the sales during the period at the end of the period and recognize it.
Liabilities: Introduction

14. Expense Warranty Using Accrued Method (contd.)
Journal Entry:
Warranty Expense xxx
Estimated Warranty Liability xxx
When warranty services provided:
Estimated warranty liability xxx
Cash (or Inventory) xxx
If the estimated warranty liabilities are not enough to cover the current year’s warranty services, additional warranty expense would be debited.
Liabilities: Introduction

15. Premiums and Coupons Obligations
Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made.
Journal Entry
Premium (or Coupon) Expense xxx
Estimated Premium Claims
(or coupon) outstanding xxx
Liabilities: Introduction

16. Premiums and Coupons Obligations (contd.)
When premiums (or coupons) are claimed:
Journal Entry
Estimated Premium Claims
(coupon) outstanding xxx
Inventory xxx
* If the actual redemption of coupons (or premiums) is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year. (APB 20)
Liabilities: Introduction

17. Liabilities: Introduction
Contingencies
Contingent Liabilities
Contingent Losses
Contingent Gains
Liabilities: Introduction

18. Contingent Liabilities
Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)
Liabilities: Introduction

19. Contingent Losses and Gains
Losses (gains) may arise because of the occurrence or not occurrence of future event(s).
(i.e., the uncollectable accounts, the pending lawsuit losses (gains), possible damage of a fire, etc.…)
Liabilities: Introduction

20. Accounting Treatments of Contingencies
The accounting treatments of the contingencies depend on the occurrence probability of the related future event(s).(FASB No. 5)
If the future event is a. Probable, and b. amount of liability can be reasonable estimated The liability should be estimated, and recognized on the balance sheet.
Liabilities: Introduction

21. Accounting Treatments of Contingencies (contd.)
Probable: defined by the FASB as “the future event(s) is(are) likely to occur”; no specific % is given.
Common practice of probable by accountants: probability of occurrence is between 80% to 85%.
IASC: Probable is defined as “more likely than not” .
Liabilities: Introduction

22. Accounting Treatments of Contingencies (contd.)
Examples:
1. Bad Debt Expenses xxx
Allowance for Bad Debt xxx
2. Warranty Expense xxx
Estimated Warranty Liabilities xxx
3. Lawsuit Expenses xxx
Estimate Liability under litigation xxx
Liabilities: Introduction

23. Accounting Treatments of Contingencies (contd.)
If the future event is probable, but the amount of loss/liability cannot be estimated, the contingent loss/liability should be disclosed (i.e., Merck’s disclosure of Vioxx lawsuits).
Contingent gains:
No unrealized gain can be recognized under the current accounting standards (conservatism!!!)
Liabilities: Introduction

24. 3. Long-Term Liabilities
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3. Long-Term Liabilities
Issuance of bonds (at a premium or discount)- cash inflow
Issuance of bonds between interest payment dates
Extinguishment of debt – cash outflow
Convertible Bonds, callable bonds
Mortgage payable and Long-term Notes Payable
Liabilities: Introduction

25. Liabilities: Introduction
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Present Value of $1
Present value concept:
Present value of $1 is the value today of $1 to be received in the future, given a specific interest rate.
Example:
1. What is the present value of $100 to be received a year from now given an annual market interest rate of 10%?
P.V.  (1+10%) = $100
P.V. = $100/1.1
= $100 
= $90.91
Liabilities: Introduction

26. Liabilities: Introduction
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Present Value (contd.)
2. What is the present value of $100 to be received two years from now given an annual interest rate of 10%?
P.V  (1+10%)  (1+10%) = $100
P.V  (1+10%)2 = $100
P.V.  1.21 = $100
P.V. = $100 / 1.21
= $100 
= $82.64
Liabilities: Introduction

27. Liabilities: Introduction
An Ordinary Annuity:
Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods
$100
1 year
What is the present value of receiving $100 every year for the following 5 years starting a year from now?
Liabilities: Introduction

28. The Present Value of an Ordinary Annuity:
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The Present Value of an Ordinary Annuity:
1. Using the example above given a10% Interest rate:
P.V. of the first $100 = $100  = $90.91
P.V. of the second $100 = $100  = $82.64
P.V. of the third $100 = $100  = $75.13
P.V. of the fourth $100 = $100  = $68.30
P.V. of the fifth $100 = $100  = $62.09
Total $379.07
Liabilities: Introduction

29. Present Value (P.V.) of an Annuity (contd.):
The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now =>
$100 * = $379.07
The P.V. of this annuity can be obtained from an annuity table under 10%, 5 periods.
Liabilities: Introduction

30. Present Value (P.V.) of an Annuity (contd.):
2. What is the P.V. of $300 annuity receiving every 6 months for the following 30 months, starting 6 months from now ? The annual interest rate is 12%.
P.V. = $300 x = 1,263.7
Annuity Table, 5 periods at 6%
(30/6=5) (12%/2=6%)
Liabilities: Introduction

31. Liabilities: Introduction
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Corporate Bonds:
Bonds are securities issued by a corporation to borrow money from the public (i.e., from many lenders/investors).
This is a source to raise funds.
The corporation will receive cash when bonds are issued.
Liabilities: Introduction

32. Liabilities: Introduction
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Corporate Bonds:
The face value of the bonds must be repaid to the bondholders on the maturity date of the bonds.
Also, the bond issuers (the borrower) will have to pay interests to the bondholders (the lender/investor) periodically (i.e., semi-annually).
Liabilities: Introduction

33. Liabilities: Introduction
Bonds Payable
Long-Term Liability: if bonds mature in more than one year.
Short-Term Liability: if bonds mature in less than one year
Liabilities: Introduction

34. Liabilities: Introduction
Bonds Payable (contd.)
Bond Indenture is an agreement States the following:
Interest rate of bonds;
Interest Payment dates;
The maturity date of bonds;
The type of bonds: callable, convertible,..
The indenture is held by a trustee appointed by the issuing firm to represent the rights of the bondholders.
Liabilities: Introduction

35. The Process of Bond Issuance
1. Receive the approval from the stockholders and regulatory authorities (i.e., the SEC).
2. Print bond certificates and write indenture (to set the terms of bond issue such as the stated interest rate, the interest payment date and the maturity date…)
3. Make a public announcement of its intent to sell the bonds on a particular date.
Liabilities: Introduction

36. The Process of Bond Issuance (cont.)
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The Process of Bond Issuance (cont.)
4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i.e., the stated inters rate), the general bond market conditions, the risk of the bonds and the expected state of the economy.
Liabilities: Introduction

37. The Process of Bond Issuance (cont.)
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The Process of Bond Issuance (cont.)
5. The underwriter will determine the effective interest rate (yield) and thus, the selling price that it believes best reflects the current market condition and the risk the bond for a particular bond issue.
6. The underwriter will either purchase the bonds from the issuing company and resell them to the public or sell these bonds for a commission.
Liabilities: Introduction

38. The Process of Bond Issuance (cont.)
Companies can sell the entire issue of bonds to an underwriter or sell it to a single investor (i.e., a pension fund) (referred to as a private placement).
Any expenditures connected with a bond issue (legal fee, printing costs, accounting fee, underwriter's charges …) should be deferred and amortized as expense over the life of the bond using a straight line method.
Liabilities: Introduction

39. The Process of Bond Issuance (Contd.)
The yield is the market rate (effective rate) for the bond issue.
The yield is often different from the stated interest rate as a result of :
1) different opinion between the underwriter and the company, or
2) a change in the economic conditions between the date the terms were set and the date the bonds were issued.
Liabilities: Introduction

40. The Process of Bond Issuance (Contd.)
Three possible outcomes of bond issuance:
1. Stated rate = effective rate (yield)
=> the bonds are sold at par
2. Stated rate < effective rate
=> bonds are sold at discount
3. Stated rate > effective rate
=> bonds are sold at premium
Liabilities: Introduction

41. Liabilities: Introduction
Units of bonds:
At $1,000 denominations or a multiple of $1,000.
Price of bonds: stated at 100s
Example: $1,000 issued at 98
The issuing price is $1,000  98 = $980
Liabilities: Introduction

42. Liabilities: Introduction
Types of bonds:
On the basis whether the bonds are secured:
Secured Bonds
Unsecured Bonds (Debentures)
On the basis of how the interests are paid:
Registered Bonds
Coupon Bonds
Liabilities: Introduction

43. Liabilities: Introduction
Types of bonds:
On the basis of how the bonds mature:
Term Bonds
Serial Bonds
Convertible Bonds
Callable Bonds
Liabilities: Introduction

44. Determination of Bond Price
The obligations of bond issuers:
(1) to pay the principal when bond matures on the maturity date.
(2) to pay interests periodically (i.e., semiannually) over the life the bond.
Liabilities: Introduction

45. Determination of Bond Price (Contd.)
Bond Price: the present value of the bond.
Present value of bonds => The sum of
(1) the present value of the principal plus
(2) the present value of the periodic interests (an annuity).
Liabilities: Introduction

46. Determination of Bond Price (Contd.)
Discount rate = effective rate = market rate =yield
This rate depends on the riskiness of the issuer, the general state of the economy, the duration of the bond, etc.
In general, a higher risk will result in a higher effective rate.
Liabilities: Introduction

47. Determination of Bond Price (Contd.)
Bonds Issued at Face Value
When the stated interest rate equals the effective interest rate, the bond price will equal the face value.
Liabilities: Introduction

48. Determination of Bond Price (Contd.)
Example 1:
Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%.
Interests are paid semiannually.
Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)?
Liabilities: Introduction

49. Determination of Bond Price (Contd.)
Example 1:
Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%.
Interests are paid semiannually.
Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)?
Liabilities: Introduction

50. Determination of Bond Price (Contd.)
(1)P.V. of the principal ($100,000 mature in 5 years, discount rate 5%, 10 periods):
$100,000  = $61,390
(2)P.V. of the interests received semiannually for 10 periods (annuity, discount rate = 5%, 10 periods)
$5,000  = 38,608.5
annuity table, 5%, 10periods
Liabilities: Introduction

51. Determination of Bond Price (Contd.)
The P.V. of the bond = the sum of (1) and (2)
= $61, ,608.5 = $100,000
Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value.
Liabilities: Introduction

52. Determination of Bond Price (Contd.)
Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value.
J.E. (when bonds are issued at face value)
Cash ,000
Bonds payable 100,000
Liabilities: Introduction

53. Determination of Bond Price (Contd.)
Question:
What’s is the total interest expense of the bond (issued at face value)?
Cash payments by the issuer* ($150,000)
Cash Rece. from issuing bonds $100,000
Interest Expense ($50,000)
* Principal on maturity date + semiannual interest payments
= $100,000 + $5,000 x 10 = $150,000
Liabilities: Introduction

54. Bond Issued at A Discount
When the stated interest rate is less than the effective interest rate, the present value of a bond will be less than its face value.
Example 2: Use the same information as in Example 1, except that the effective rate is 12%, rather than 10% to compute the present value of the bond.
Liabilities: Introduction

55. Bond Issued at A Discount (Contd.)
Since the interests are paid semiannually, the discount rate is 6% with 10 periods.
(1)P.V. of the principal = $100,000 .5584 = $55,840 
P.V. table, 6%, 10periods
(2) P.V. of the semiannual interest:
$5,000  = 36,800.5
Annuity table, 6%, 10periods
P.V. of the bond = (1) + (2)
$55, ,800.5 = $92,640.5
Liabilities: Introduction

56. Bond Issued at A Discount (Contd.)
P.V. of bond < Face vale
=> when the stated rate is less than the effective rate (i.e., 10% < 12%), the P.V. of the bond will be less than the face value.
J.E. (when bonds are issued at discount)
Cash 92,640.5
Discount on Bonds 7,359.5
Bonds Payable 100,000
Liabilities: Introduction

57. Bond Issued at A Discount (Contd.)
Question:
What is the total interest expense of this bond (issued at Discount)?
Cash payment by the issuer ($150,000)
Cash received from issuing the bond (at Discount) ,640.5
Interest Expense $57,359.50*
Discount would increase the actual interest expense and needs to be amortized over the life of the bond.
*Interest Expense = interest payment + Discount
= $50, , = $57,359.50
Liabilities: Introduction

58. Bond Issued at A Premium
When the stated interest rate is higher than the effective interest rate demanded by the investors for the level of the risk of the bonds, the present value of the bonds would be greater than its face value.
Example 3: use the same information as in Example 1, except that the effective interest rate is 8%. (the stated interest rate is still at 10%)
Liabilities: Introduction

59. Bond Issued at A Premium (Contd.)
Compute the P.V. of the bond:
Since the interests are paid semiannually, the discount rate would be 4% and the discounting periods are 10 periods.
(1) P.V. of the principal:
$100,000 x = $67,560
Liabilities: Introduction

60. Bond Issued at A Premium (Contd.)
(2) P.V. of the semiannual interest:
$5,000 x = $40,554.5
P.V. of the bond = (1) + (2)
= $67, ,554.5 = $108,114.5
$108,114.5 > $100,000 (Premium = 8,114.5)
Liabilities: Introduction

61. Bond Issued at A Premium (Contd.)
Example 3
J.E. (Bonds are issued at a Premium)
Cash ,114.5
Bonds Payable ,000
Premium on Bonds Payable 8,114.50
Liabilities: Introduction

62. Bond Issued at A Premium (Contd.)
Question: What is the total interest expense of the bond (issued at Premium)?
Cash payments by the issuer (150,000)
Cash received from issuing the bond ,114.5
Interest Expense ($41,885.5)
Liabilities: Introduction

63. Bond Issued at A Premium (Contd.)
Question: What is the total interest expense of the bond (issued at Premium)?
Cash payments by the issuer (150,000)
Cash received from issuing the bond ,114.5
Interest Expense ($41,885.5)
Note: Regardless of the market interest rate, the total cash payments are the sample (i.e., $150,000) with the same stated interest rate and same par value.
Liabilities: Introduction

64. Bond Issued at A Premium (Contd.)
A premium account: an adjunct account to the bonds payable account and is shown as an addition to the bonds payable account.
A discount account: a contra account to the bonds payable and is shown as a deduction from the bonds payable.
Liabilities: Introduction

65. Bond Issued at A Premium (Contd.)
Book value (carrying value) of the bond issued: the face value plus any unamortized premiums or minus any unamortized discounts.
If an effective interest method is used to amortize the discount (or premium), the carrying value equals the present value under the historical effective interest rate.
Liabilities: Introduction

66. 4. Accounting for Bonds Payable - Bonds Are Issued at A Discount
Information of example 2 is summarized below with some additional information:
Stated Interest = 10% (annual)
Effective Interest = 12% (annual)
Date of Issuance = 1/1/x2 (sold on 1/1/x2)
Date of Maturity = 1/1/x7
Interest Payment Dates = 6/30 and 12/31
Face Value = $100,000
P.V. of the Bond = 92, (as computed earlier)
Liabilities: Introduction

67. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
This discount would increase the interest expense and would be amortized over the life of the bond -5 year, 10 periods)
Liabilities: Introduction

68. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
Amortization methods:
1. Straight-Line: the Discount would be amortized equally over the life of the bond.
i.e., Amortization in 10 periods:
$ 10 = $735.95
Therefore, the interest expense every period is
$5, ,35.95 = $5,735.95
Semiannual the amortized Discount
Interest Payment
Liabilities: Introduction

69. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
Total Interest expense
= 5, x 10 = $5,7359.5
= 50, ,359.5
 
Int. payment Discount
2. Effective Interest Method
Interest Expense
= P.V. of Bond  effective rate
Liabilities: Introduction

70. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
J.E (Bonds are issued at a discount and use the straight-line method to amortize the discount)
1/1/x2 Cash
Discount on B/P
B/P ,000
6/30/x2 Interest Expense 5,736
Cash *
Discount on B/P **
12/31/x2 Interest Expense 5,736
Cash 5,000
Discount on B/P
Liabilities: Introduction

71. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
12/31/x6 Interest Expense 5,736
Cash 5,000
Discount on Bonds Payable
1/1/x7 B/P ,000
Cash ,000
Discount on Bonds
1/1/x2 7, /30/x2
/31/x2
/30/x3
/31/x6
Interest Expense from 1/1/x2 to 12/31/x6
= $ 5, * 10
= $5,7,359.50
= $50, ,359.5
Interest payments
Liabilities: Introduction

72. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
J.E. for bonds issued at a discount and use the effective interest method to amortize the discount: using the example on p.48.
Interest Payment = $100,000 * 5%= $5,000
Interest Expense = P.V. of Bond at the Beginning of the period  Effective Rate
Amortized Discount = Interest Expense - Interest payment
Liabilities: Introduction

73. Effective Interest Amortization Table-bond are issued at a discount
Liabilities: Introduction

74. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
J.E :
1/1/x2 Cash 92,641
Discount on B/P 7,359
B/P ,000
6/30/x2 Interest Expense 5,558
(period 1) Cash 5,000
Discount on B/P
12/31/x2 Interest Expense 5,592
(period 2) Cash 5,000
Discount on B/P
Liabilities: Introduction

75. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
6/30/x3 Interest Expense 5,672
Cash 5,000
Discount on B/ P :
6/30/x6 Interest Expense 5,890
Discount on B/P
12/31/x6 Interest Expense 5,944
Discount on B/P
1/1/x7 B/P ,000
Cash ,000
Liabilities: Introduction

76. Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)
Discount on Bonds Payable
1/1/x2 7, …6/30/x2
592…12/31/x2
672…6/30/x3
890…6/30/x6
944…12/31/x6
Interest Expense over 10 periods =>
Period 1 $5,558
Period 2 $5,592
period 3 $5,627
Period 9 $ 5,890
Period 10 $ 5,944
$57,359
$57360= $50, ,359
Liabilities: Introduction

77. Accounting for Bonds Payable -Bonds Are Issued at A Premium
Information of example 3 is summarized with some additional information:
Stated Interest Rate (annual) = 10%
Effective Interest Rate (annual) = 8%
Date of Issuance = 1/1/x2 (sold on 1/1/x2)
Date of Maturity = 1/1/x7
Interest Payment Date = 6/30 and 12/31
Face Value = $100,000
P.V. of the Bond = $108,115 (as computed earlier)
Liabilities: Introduction

78. Accounting for Bonds Payable-Bonds Are Issued at A Premium
The premium would decrease the interest expense and should be amortized over the life (5 years, 10 periods) of the bond.
J.E. (Amortization Method= Straight-Line)
$8,114.5 / 10 = $ => $ would be amortized for every period. The interest expense would be decreased by $816 every period.
1/1/x2 Cash 108,114.5
B/P ,000
Premium on Bonds Payable 8,114.5
Liabilities: Introduction

79. Effective Interest Amortization Table-bond are issued at a premium
Interest Expense = Cash payment - Amortized premium
= 50,
= 41,885.5
* Rounding Error of $ 7 ( = 7)
Liabilities: Introduction

80. Accounting for Bonds Payable (Contd.)
Premium on Bonds
6/30/x2… …1/1/x2
12/31/x2 … 702
730
760
790
822
855
889
924
968
Interest Expense over 10 periods =>
Period $
1 4,325
2 4,298
4,270 10
41,885.50
Liabilities: Introduction

81. Accounting for Bonds Sold Between Interest Payment Dates:
Policy of interest payment for bonds:
Interest are always paid in full regardless how long the bonds being held by the bondholder.
Thus, the bond issuing company collects the accrued interests in addition to the issuing price when bonds are sold between interest payment dates.
Liabilities: Introduction

82. Accounting for Bonds sold Between Interest Payment Dates at Par:
Example: assume that on 2/1/x2, Page company issued a 5- year term bond with a face amount of $100,000 and a stated interest rate of 10%. The bonds were issued at Par and interests were paid semiannually on 2/1 and 8/1. The bonds were sold on 5/1/x2.
Liabilities: Introduction

83. Accounting for Bonds Sold Between Interest Payment Dates at Par:
J.E. 5/1/x2 (bond sold at par on 5/1/x2)
Cash ,500
Bonds Payable ,000
Interest Payable* ,500
* Accrued interest of 3 months (From 2/1 ~ 5/1)
8/1/x2 Interest Payable* 2,500
Interest Payable ,500
Cash 5,000
* 100,000 x 10% x 6/12 = 5,000 (6 month interest)
Actual Interest Expense (from 5/1/x2 - 8/1/x2) =>
5,000 -2,500 = 2,500
Liabilities: Introduction

84. 5. Bond Retirements Before Maturity
Use example 2 (issued at a discount), assume that bonds are retired at the end of period 3 for $98,000
Discount on Bonds
7, …..Period 1
592…..Period 2
627…..Period 3
5,582
Unamortized at the end of period 3
BV of the Bond = 100, ,582 = 94,418
Liabilities: Introduction

85. Bond Retirements Before Maturity
B/P ,000
Loss on Retirement of Bonds ,582
Discount on Bonds Payable 5,582
Cash ,000
Liabilities: Introduction

86. 6. Long-Term Notes Payable
APB Opinion No. 21 requires the long-term notes payable to be recorded at their present values and the effective interest method is used to record the subsequent interest.
The effective interest rate (or implicit rate) is the rate that equates the future net cash flows to the present value.
Liabilities: Introduction

87. Long-Term Notes Payable (contd.)
Therefore, if the present value (p.v.) and future net cash flows are known, the effective interest can be calculated.
Also, if both the effective interest rate and future net cash flows are known, the present value can be calculated.
Liabilities: Introduction

88. Long-Term Notes Payable (contd.)
In other cases, when the P.V. is not known, the incremental interest rate of the borrower is used as the effective rate to calculate the P.V. of the note.
Liabilities: Introduction

89. Long-Term Notes Payable (contd.)
A. Notes payable issued for cash:
When a long-term note is exchanged for cash, the note is assumed to have a present value equals the cash proceeds.
The difference between the cash proceeds and the face value of the note is recorded as a discount (or premium)
The discount (or premium) is amortized over the life of the note using the effective interest method.
Liabilities: Introduction

90. Liabilities: Introduction
Example A
Johnson Company issued a 3-year, non-interest-bearing note with a face value of $8,000 and received $5, in exchange. The journal entry to record the issuance is:
Cash 5,694.24
Discount on
Notes Payable 2,305.76
Note Payable 8,000
Liabilities: Introduction

91. Liabilities: Introduction
Example (contd.)
The discount account is a contra account to notes payable. The effective interest rate that equates the P.V. of 5, to $8,000 at the end of 3 years is 12%.
5, = 8,000 x  3-period, 12%
Liabilities: Introduction

92. Liabilities: Introduction
Example (contd.)
The Interest Expense Per Year is Computed as:
Liabilities: Introduction

93. Liabilities: Introduction
Example (contd.)
Recognition of Interest Expense of Year 1:
Interest Expense
Discount on N/P
Cash
(non-interest bearing note) 0
Liabilities: Introduction

94. Notes Payable Exchanged for Property, Goods, or Services
APB opinion No.21 requires the note be recorded at the fair market value of the property, goods, or services or the fair market value of the note (I.e., the present value of the note is known), whichever is more reliable.
And, the effective interest rate is calculated (when both the P.V. and future cash flows are known) and used to calculate subsequent interest expense using the effective interest method.
Liabilities: Introduction

95. Notes Payable Exchanged for Property, Goods, or Services (contd.)
If neither of these values is determinable, the incremental borrowing rate of the borrower is used as the effective interest rate to calculate the P.V. of the note and the interest expense of subsequent years using the effective interest method.
Liabilities: Introduction

96. Liabilities: Introduction
Example B
On 1/1/x5, Marden Company purchases an equipment by issuing a non-interest-bearing 5-year note with a face value of $10,000.
Neither the fair market value of the equipment nor that of the note is determinable.
The incremental borrowing rate of Marden is 12%.
Liabilities: Introduction

97. Liabilities: Introduction
Example (contd.)
J.E. 1/1/x5
Equipment 5,674.27*
Discount on N/P 4,325.73
N/P 10,000
* P.V. of the note using 12% as the effective interest rate => 10,000 x
Liabilities: Introduction

98. Liabilities: Introduction
Example (contd.)
12/31/x5
Int. Exp. ( x 12%)
Discount on N/P
Depreciation Expense
Accumulated Depreciation
(Assuming a S-L depreciation method is used and a 10-year life is assumed for the equipment)
Liabilities: Introduction

99. Liabilities: Introduction
Example (contd.)
12/31/x6
Int. Exp. (5, ) x 12% 762,62
Discount on N/P
Depreciation Expense
Accumulated Depreciation
Liabilities: Introduction

100. Liabilities: Introduction
Example C
Using the Example B, except that the fair market value the equipment was determined at $6, The interest rate that equates the future cash flows to the present value of $6, is 10%.
Liabilities: Introduction

101. Liabilities: Introduction
Example (contd.)
The following entries would be recorded for 20x5 and 20x6:
1/1/x5
Equipment 6,209.21
Discount on N/P 3,790.89
N/P 10,000
12/31/x5
Int. Exp. (6, x 10%) 621
Discount on N/P 621
12/31/x6
Int. Exp. (6, ) x 10% 683
Discount on N/P 683
Liabilities: Introduction

102. Liabilities: Introduction
Example (contd.)
Regardless of the effective interest rate on the long-term note payable, the total expense (interest expense on the unpaid portion of the note plus the depreciation expense of the acquired asset) charged by the company is the same (i.e., $10,000).
Liabilities: Introduction

103. Installment Notes – Example D
Notes could be paid by installments (a constant amount paid periodically) rather than by a single amount at maturity.
Using Example B (on p95), assuming an installment payment at the end of each year for the following 5 years, ( starting 12/31/x5), the annual installment payment for the note (loan) equals: $6,209.21/ =$1,638
Liabilities: Introduction

104. Installment Notes: (Contd.)
Journal Entries:
1/1/x5 Equipment 6, Note Payable 6,209.21
12/31/x5 Interest Exp. * N/P , Cash 1,638 *6, x 10% = 621
12/31/x6 Interest Exp. * N/P , Cash 1,638 *(6, ,017) x 10% = 519.2
Liabilities: Introduction

105. Installment Notes: (Contd.)
Journal Entries:
12/31/x7 Interest Exp. * N/P , Cash 1, *(6,209-1,017-1,119) x 10% = 407
12/31/x8 Interest Exp. * N/P , Cash 1,638 *(6,209-1,017-1,119-1,231) x 10% = 284
12/31/x9 Interest Exp. * N/P , Cash 1,638
*(6,209-1,017-1,119-1,231- 1,354) x10% = 149
Liabilities: Introduction

106. Installment Notes: (Contd.)
N/P
1119
1231
1354
1489 0*
rounding error = $1
Liabilities: Introduction

107. Liabilities: Introduction
Mortgage Payable
If the note of Example C was issued for cash, it becomes a mortgage payable example. The journal entries are as follows:
Cash 6, Mortgage Payable 6,209.21
Liabilities: Introduction

108. Mortgage Payable (contd.)
12/31/x5 Interest Exp. * Mortgage Pay.1, Cash 1,638 *6, x 10% = 621
12/31/x6 Interest Exp. * M/P , Cash 1,638 *(6, ,017) x 10% = 519.2
Liabilities: Introduction

109. Installment Notes: (Contd.)
An installment note typically is recorded at its carrying amount (i.e., the face amount - the unamortized discount).
This is because the outstanding balance of an installment does not become its face amount as in the case for notes with a single payment at maturity.
Liabilities: Introduction