Chapter 12 Long-Term Liabilities

Chapter 12 Long-Term Liabilities

© Pearson Education, Inc.
Learning Objectives Journalize transactions for long-term notes payable and mortgages payable Describe bonds payable Journalize transactions for bonds payable and interest expense using the straight-line amortization method © Pearson Education, Inc.

Learning Objectives Journalize transactions to retire bonds payable Report liabilities on the balance sheet Use the debt to equity ratio to evaluate business performance © Pearson Education, Inc.

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

Learning Objective 1 Journalize transactions for long-term notes payable and mortgages payable © Pearson Education, Inc.

How Are Long-Term Notes Payable and Mortgages Payable Accounted For?
Long-term liabilities are liabilities that do not need to be paid within one year or within the entity’s operating cycle, whichever is longer. These liabilities are reported in the long-term liability section of the balance sheet. Common long-term liabilities are: Long-term notes payable Mortgages payable Long-term liabilities are liabilities that do not need to be paid within one year or within the entity’s operating cycle, whichever is longer. Both long-term notes payable and mortgages payable are common long-term liabilities. Long-term notes payable are typically reported in the long-term liabilities section of the balance sheet. © Pearson Education, Inc.

Long-Term Notes Payable
On December 31, 2016, Smart Touch Learning signed a $20,000 note payable. It is due in four annual payments of $5,000 plus 6% interest each December 31. Recall that most long-term notes payable are paid in installments. The current portion of notes payable is the principal amount that will be paid within one year—a current liability. The remaining portion is long-term. For example, Smart Touch Learning signed a $20,000 note payable on December 31, The note will be paid over four years with payments of $5,000 plus 6% interest each December 31, beginning December 31, Remember that the current portion of the note, the amount due December 31, 2017, $5,000, is considered a current liability at December 31, 2016. The entry will require a debit to Cash for $20,000 and a credit to Notes Payable for $20,000. © Pearson Education, Inc.

An amortization schedule details each loan payment’s allocation between principal and interest and the beginning and ending balances of the loan. Interest is computed as beginning balance × interest rate × time. On December 31, 2017, Smart Touch Learning will make a $5,000 principal payment plus interest. An amortization schedule is a schedule that details each loan payment’s allocation between principal and interest and the beginning and ending loan balances. Smart Touch Learning will calculate interest expense as beginning balance × interest rate × time. The total cash payment is the principal payment plus interest. © Pearson Education, Inc.

When a loan is taken out, an amortization schedule is prepared, showing payments and interest over the term of the loan. Exhibit 12-1 shows an amortization schedule for the notes payable. © Pearson Education, Inc.

Record the payment at December 31, 2017. Assume it is now December 31, 2017, and Smart Touch Learning must make its first installment payment of $5,000 principal plus interest on the note. The entry requires a debit to Notes Payable for $5,000, a debit to Interest Expense for $1,200, and a credit to Cash for $6,200. After the December 31, 2017, entry, Smart Touch Learning owes $15,000 ($20,000 original note amount minus the $5,000 principal paid on December 31, 2017). The company will record similar entries for the three remaining payments, using the amounts calculated in the amortization schedule. © Pearson Education, Inc.

Mortgages Payable Mortgages payable are long-term debts that are backed with a security interest in specific property. Mortgages payable are similar to long-term notes payable except that mortgages payable are secured with specific assets, and long-term notes payable are not. Mortgages payable include the borrower’s promise to transfer the legal title to specific assets if the mortgage isn’t paid on schedule. Mortgages payable are very similar to long-term notes payable. The main difference is the mortgages payable are secured with specific assets, whereas long-term notes are not secured with specific assets. Like long-term notes payable, the total mortgages payable amount has a portion due within one year (current) and a portion that is due more than one year from a specific date. Commonly, mortgages specify a monthly payment of principal and interest to the lender (usually a bank). The most common type of mortgage is on property (for example, a mortgage on your home). © Pearson Education, Inc.

Mortgages Payable On December 31, 2016, Smart Touch Learning purchases a building for $150,000, paying $49,925 in cash and signing a 30-year mortgage for $100,075 at 6% interest with $600 payments beginning January 31, 2017. Assume that on December 31, 2016, Smart Touch Learning purchases a building for $150,000, paying $49,925 in cash and signing a 30-year mortgage for $100,075, taken out at 6% interest that is payable in $600 monthly payments, which includes principal and interest, beginning January 31, 2017. © Pearson Education, Inc.

Mortgages Payable A partial amortization schedule for 2016 and 2017 is shown in Exhibit 12-2. © Pearson Education, Inc.

Mortgages Payable Smart Touch Learning records the first mortgage payment by debiting Mortgage Payable $99.62 and Interest Expense $ It then credits Cash for $600. We can confirm the interest calculations provided in the amortization table. The first payment on the interest is calculated as $100, × 6% × 1/12, or $ The principal of $99.62 is the difference between the monthly payment of $ and the interest expense of $ ($ ‒ $ = $99.62). The $99.62 reduces Mortgages Payable from $100, to $99, ($100, ‒ $99.62 = $99,975.38). Each mortgage payment will be recorded in a similar journal entry, using the amortization schedule amounts. © Pearson Education, Inc.

Learning Objective 2 Describe bonds payable © Pearson Education, Inc.

What Are Bonds? Bonds payable are long-term debts issued to multiple lenders called bondholders, usually in increments of $1,000 per bond. Face value is the amount a borrower must pay back to the bondholders on the maturity date. Large companies need large amounts of money to finance their operations. They may take out long-term loans from banks and/or issue bonds payable to the public to raise the money. Bonds payable are long-term debts issued to multiple lenders called bondholders, usually in increments of $1,000 per bond. By issuing bonds payable, companies can borrow millions of dollars from thousands of investors rather than depend on a loan from one single bank or lender. Each investor can buy a specified amount of the company’s bonds. The face value is the amount a borrower must pay back to the bondholders on the maturity date. Face value is also called maturity value, principal amount, or par value. Face value Maturity value Principal amount Par value © Pearson Education, Inc.

What Are Bonds? The maturity date is the date on which the borrower must pay the principal amount to the bondholders. Stated interest rate is the interest rate that determines the amount of cash interest the borrower pays and the investor receives each year. The maturity date is the date on which the borrower must pay the principal amount to the bondholders. The stated interest rate is the interest rate that determines the amount of cash interest the borrower pays and the investor receives each year. The stated rate is also called face rate, coupon rate, or nominal rate. Stated rate Face rate Coupon rate Nominal rate © Pearson Education, Inc.

What Are Bonds? Exhibit 12-3 shows a bond certificate issued by Smart Touch Learning. © Pearson Education, Inc.

Types of Bonds Term bonds are bonds that all mature at the same time. Serial bonds are bonds that mature in installments at regular intervals. Secured bonds are bonds that give bondholders the right to take specified assets of the issuer if the issuer fails to pay principal or interest. Debentures are unsecured bonds backed only by the creditworthiness of the bond issuer. There are various types of bonds, including the following: Term bonds—These bonds all mature at the same time. For example, $100,000 of term bonds may all mature five years from today. Serial bonds—These bonds mature in installments at regular intervals. For example, a $500,000, five-year serial bond may mature in $100,000 annual installments over a five-year period. Secured bonds—These bonds give the bondholder the right to take specified assets of the issuer if the issuer fails to pay principal or interest. Debentures—These bonds are unsecured bonds that are not backed by assets. They are backed only by the creditworthiness of the bond issuer. © Pearson Education, Inc.

Bond Prices A bond can be issued at any price agreed upon by the issuer and the bondholders. A bond can be issued at any of the following: Face value Discount on bonds payable, which occurs when the issue price is less than face value Premium on bonds payable, which occurs when the issue price is above face value A bond can be issued at any price agreed upon by the issuer and the bondholders. A bond can be issued at any of the following: Face value. Occurs when a bond is issued at face value. Example: A $1,000 bond issued for $1,000. Discount. A discount on bonds payable occurs when the issue price is less than face value. Example: A $1,000 bond issued for $980. The discount is $20 ($1,000 ‒ $980). Premium. A premium on bonds payable occurs when the issue price is above face value. Example: A $1,000 bond issued for $1,015. The premium is $15 ($1,015 ‒ $1,000). The issue price of a bond does not affect the required payment at maturity. In all of the preceding cases, the company must pay the face value of the bonds at the maturity date stated on the face of the bond. The issue price of a bond determines the amount of cash the company receives when it issues the bond. In all cases, the company must pay the bond’s face value to retire it at the maturity date. © Pearson Education, Inc.

Bond Prices Exhibit 12-4 shows example price information for the bonds of Smart Touch Learning. Exhibit 12-4 shows example price information for the bonds of Smart Touch Learning. On this particular day, 12 of Smart Touch Learning’s 9% bonds maturing in 2021 (indicated by 21) were traded. The bonds’ highest price on this day was $795 ($1,000 × 0.795). The lowest price of the day was $ ($1,000 × ). The closing price (last sale of the day) was $795. © Pearson Education, Inc.

Present Value Money earns interest over time. The time value of money is the recognition that money earns interest over time. The present value is the amount a person would invest now to receive a greater amount in the future. Money earns interest over time, a fact called the time value of money. The time value of money is the recognition that money earns interest over time. The present value is the amount a person would invest now to receive a greater amount in the future. © Pearson Education, Inc.

Bond Interest Rates The stated rate is the rate printed on a bond. The market interest rate is the rate that investors demand to earn for loaning their money. Bonds are sold at their market price (issue price on the date the bonds are first sold), which is the present value of the interest payments the bondholder will receive while holding the bond plus the present value of the bond principal paid at the end of the bond’s life. Two interest rates work together to set the price of a bond: The stated interest rate determines the amount of cash interest the borrower pays each year. The stated interest rate is printed on the bond and does not change from year to year. The dollar amount of interest paid is not affected by the issue price of the bond. The market interest rate (also known as the effective interest rate) is the rate that investors demand to earn for loaning their money. The market interest rate varies constantly. A company may issue bonds with a stated rate that differs from the market interest rate, due to the time gap between the time the bonds were printed (engraved) showing the stated rate and the actual issuance of the bonds. Exhibit 12-5 shows how the stated interest rate and the market interest rate work together to determine the price of a bond. © Pearson Education, Inc.

Issuing Bonds Versus Issuing Stock
Borrowing by issuing bonds payable carries a risk: The company may be unable to pay off the bonds and the related interest. However, debt is a less expensive source of capital than stock and does not affect the ownership percentage. Earning more income on borrowed money than the related interest expense is called financial leverage. Borrowing by issuing bonds payable carries a risk: The company may be unable to pay off the bonds and the related interest. Why do companies borrow instead of issuing stock? Debt is a less expensive source of capital than stock, and bonds do not affect the percentage of ownership of the corporation. Companies face the following decision: How shall we finance a new project—with bonds or with stock? Financial leverage occurs when a company earns more income on borrowed money than the related interest expense. © Pearson Education, Inc.

Issuing Bonds Versus Issuing Stock
Smart Touch Learning’s management believes the new cash can be used to increase income before interest and taxes by $200,000 each year. The company estimates income tax expense to be 40%. Exhibit 12-6 shows the advantage of borrowing as it relates to earnings per share. © Pearson Education, Inc.

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

How Are Bonds Payable Accounted for Using the Straight-line Amortization Method? Journal entries are required to record the issuance of bonds at: Face value Discount Premium Bonds are a long-term liability. The basic journal entry to record the issuance of bonds payable debits Cash and credits Bonds Payable. As noted previously, a company may issue bonds, a long-term liability, at face value, at a discount, or at a premium. © Pearson Education, Inc.

Issuing 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 at face value on January 1, 2016. Smart Touch Learning has $100,000 of 9% bonds payable that mature in five years. The company issues the bonds at face value on January 1, Smart Touch Learning, the borrower, makes this one-time journal entry to record the receipt of cash and issuance of bonds payable. The entry includes a debit to Cash and a credit to Bonds Payable for the face value of the bonds, $100,000. © Pearson Education, Inc.

Issuing Bonds Payable at Face Value
Interest payments occur each June 30 and December 31. Smart Touch Learning’s first semiannual interest payment is journalized as follows: Interest payments occur each June 30 and December 31. Smart Touch Learning’s interest journal entry includes a debit to Interest Expense for $4,500 ($100,000 × 0.09 × 6/12) and a credit to Cash for $4,500. Each semiannual interest payment follows this pattern. © Pearson Education, Inc.

Issuing Bonds Payable at a Discount
Smart Touch Learning issues $100,000 of 9%, five-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. We know that market conditions may force a company such as Smart Touch Learning to accept a discounted price for its bonds. Suppose Smart Touch Learning issues $100,000 of its 9%, five-year bonds that pay interest semiannually when the market interest rate is 10%. The market price of the bonds drops to $96.149, which means % of face value. Smart Touch Learning receives $96,149 ($100,000 × ) at issuance and records a debit to cash for $96,149, a debit to Discount on Bonds Payable of $3,851 ($100,000 ‒ $96,149), and a credit to Bonds Payable of $100,000. © Pearson Education, Inc.

Issuing Bonds Payable at a Discount
Discount on Bonds Payable is a contra account to Bonds Payable. Bonds Payable minus the discount gives the carrying amount of bonds, also known as the carrying value. Discount on Bonds Payable is a contra account to Bonds Payable. Bonds Payable minus the discount gives the carrying amount of bonds (also known as the carrying value). The carrying amount of bonds is the bonds payable minus the discount account current balance or plus the premium account current balance. Smart Touch Learning would report these bonds payable on the balance sheet under the long-term liabilities section with $100,000 shown as Bonds Payable and $3,851 as Discount on Bonds Payable, for a carrying value of $96,149. © Pearson Education, Inc.

Straight-Line Amortization of Bond Discount
We can amortize a bond discount using the straight-line amortization method. We can amortize a bond discount by dividing it into equal amounts for each interest period. This is called the straight-line amortization method. The straight-line amortization method is an amortization method that allocates an equal amount of bond discount or premium to each interest period over the life of the bond. It works very much like the straight-line depreciation method we discussed for plant assets in Chapter 9. © Pearson Education, Inc.

Straight-Line Amortization of Bond Discount
Using the discount amortization table, record Smart Touch Learning’s first interest payment on June 30, 2016. In our example, the initial discount is $3,851, and there are 10 semiannual interest periods during the bonds’ five-year life (5-year life × 2 interest payments per year). Therefore, 1/10 of the $3,851 bond discount ($385, rounded) is amortized each interest period. The entry requires a debit to Interest Expense for $4,885, a credit to Cash for $4,500, and a credit to Discount on Bonds Payable of $385. On the December 31, 2016, balance sheet, Smart Touch Learning reports Bond Payable at $100,000 and Discount on Bonds Payable of $3,081. The carrying value is now $96,919. © Pearson Education, Inc.

Issuing Bonds Payable at a Premium
When the stated interest rate is greater than the market interest rate, the bonds are sold at a premium. Premium on Bonds Payable is an adjunct account to Bonds Payable. An adjunct account is an account that is directly related to another account. The Bonds Payable account and the Premium on Bonds Payable account each carry a credit balance. Premium on Bonds Payable is an adjunct account to Bonds Payable. An adjunct account is an account that is directly related to another account. Adjunct accounts have the same normal balance as the related account and are added to the related account on the balance sheet. Adjunct accounts work similarly to contra accounts; the only difference is that an adjunct account has the same type of balance as the main account, whereas the contra account has the opposite type of balance of its main accounts. Therefore, we add Premium on Bonds Payable to the Bonds Payable to determine the bonds’ carrying value. © Pearson Education, Inc.

Issuing Bonds Payable at a Premium
Smart Touch Learning issues its 9%, five-year bonds when the market interest rate is 8%. Assume the bonds are priced at , and Smart Touch Learning receives $104,100 cash upon issuance. To illustrate a bond premium, let’s change the Smart Touch Learning example. Assume that the market interest rate is 8% when Smart Touch Learning issues its 9%, five-year bonds. These 9% bonds are attractive in an 8% market, and investors will pay a premium to acquire them. Assume the bonds are priced at (104.1% of face value). In this case, Smart Touch Learning receives $104,100 cash upon issuance. Smart Touch Learning records a debit to Cash of $104,100, a credit to Premium on Bonds Payable of $4,100 ($104,100 – $100,000), and a credit to Bonds Payable of $100,000. © Pearson Education, Inc.

Straight-Line Amortization of Bond Premium
The beginning premium is $4,100, and there are 10 semiannual interest periods during the bonds’ five-year life. Therefore, 1/10 of the $4,100 ($410) of bond premium is amortized each interest period. Interest expense of $4,090 is the stated interest of $4,500, which is paid in cash, minus the amortization of the premium of $410. This same entry would be made again on December 31, So, the bond premium balance would be $3,280 on December 31, 2016. © Pearson Education, Inc.

Straight-Line Amortization of Bond Premium
Exhibit 12-8 shows the amortization schedule of a bond when issued at a premium. © Pearson Education, Inc.

Learning Objective 4 Journalize transactions to retire bonds payable © Pearson Education, Inc.

How Is the Retirement of Bonds Payable Accounted For?
Retirement of bonds payable involves paying the face value of the bonds. Bonds can be retired at the maturity date or before. When a bond is matured, the carrying value always equals the face value. © Pearson Education, Inc.

Retirement of Bonds 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.) In the case of Smart Touch Learning, with both the discount and premium examples, on December 31, 2020, the carrying amount and face value are $100,000. The entry to retire the bonds includes a debit to Bonds Payable of $100,000 and a credit to Cash of $100,000. © Pearson Education, Inc.

Retirement of Bonds Before Maturity
Companies sometimes retire their bonds prior to maturity. The main reason is to relieve the pressure of paying interest payments. Some bonds are callable bonds, which means the company may call, or pay off, the bonds at a specified price. Normally, companies wait until maturity to pay off, or retire, their bonds payable. But companies sometimes retire their bonds prior to maturity. The main reason for retiring bonds early is to relieve the pressure of paying the interest payments. Some bonds are callable. Callable bonds are bonds that the issuer may call and pay off at a specific price whenever the issuer wants. The call price is usually 100 or a few percentage points above face value, perhaps 101 or 102, to provide an incentive for the bondholder. Callable bonds give the issuer the flexibility to pay off the bonds when doing so benefits the company. An alternative to calling the bonds is to purchase any available bonds in the open market at their current market price. Whether the bonds are called or purchased in the open market, the same accounts are used in the journal entry. © Pearson Education, Inc.

On December 31, 2016, Smart Touch Learning has $100,000 of bonds payable outstanding, with a remaining discount balance of $3,081. The company can buy the bonds in the open market for 95. Suppose on December 31, 2016, Smart Touch Learning has $100,000 of bonds payable outstanding, with a remaining discount balance of $3,081 (the original discount of $3,851 [$100,000 ‒ $96,149] less the straight-line amortization of $385 in June and December [$3,851 ‒ $385 ‒ $385]). Lower interest rates have convinced management to pay off these bonds now. These bonds are callable at 100. If the market price of the bonds is 95, should Smart Touch Learning call the bonds at 100 or purchase them in the open market at 95? The market price is lower than the call price, so Smart Touch Learning should buy the bonds on the open market at their market price. Retiring the bonds on December 31, 2016, at 95 results in a gain of $1,919 (the carrying value of $96,919 less the market price of $95,000). © Pearson Education, Inc.

The journal entry to record the retirement includes a gain on retirement of the bonds. The entry will require that the bonds be removed from the books by recording a debit to Bonds Payable of $100,000, a credit to the remaining Discount on Bonds Payable of $3,081, and a credit to Cash of $95,000. In order to balance the journal entry, a Gain on Retirement of Bonds will need to be recorded, with a credit of $1,919. © Pearson Education, Inc.

Learning Objective 5 Report liabilities on the balance sheet © Pearson Education, Inc.

How Are Liabilities Reported on the Balance Sheet?
At the end of each period, all current and long-term liabilities are reported on the balance sheet. When a company issues bonds, a discount or premium will be included in the section with the bonds payable. At the end of each period, a company reports all of its current and long-term liabilities on the balance sheet. As we have seen throughout the textbook, there are two categories of liabilities: current and long-term. © Pearson Education, Inc.

How Are Liabilities Reported on the Balance Sheet?
Exhibit 12-9 shows Smart Touch Learning’s liabilities portion of its balance sheet (amounts assumed) that we have discussed up to this point. © Pearson Education, Inc.

Learning Objective 6 Use the debt to equity ratio to evaluate business performance © Pearson Education, Inc.

How Do We Use the Debt to Equity Ratio to Evaluate Business Performance? The relationship between total liabilities and total equity is called the debt to equity ratio. The debt to equity ratio shows the proportion of total liabilities to total equity. This ratio measures financial leverage. A ratio greater than 1 indicates the company is financing more assets with debt than with equity. The relationship between total liabilities and total equity—called the debt to equity ratio—shows the proportion of total liabilities relative to the total equity. Thus, this ratio measures financial leverage. If the debt to equity ratio is greater than 1, then the company is financing more assets with debt than with equity. If the ratio is less than 1, the company is financing more assets with equity than with debt. The higher the debt to equity ratio, the greater the company’s financial risk. © Pearson Education, Inc.

How Do We Use the Debt to Equity Ratio to Evaluate Business Performance? Green Mountain Coffee Roasters, Inc., reported total liabilities and total equity (in thousands) on its fiscal 2013 Annual Report as follows: Using the information for Green Mountain Coffee Roasters, calculate the debt to equity ratio for 2013. © Pearson Education, Inc.

How Do We Use the Debt to Equity Ratio to Evaluate Business Performance? Green Mountain’s debt to equity ratio as of September 28, 3013, is calculated as follows: Green Mountain’s debt to equity ratio is well below 1, indicating that the company is financing more assets with equity than with debt. Green Mountain’s debt to equity ratio is well below 1, indicating that the company is financing more assets with equity than with debt. Notice that its debt to equity ratio has improved from 2012, when Green Mountain had a debt to equity ratio of 0.60 ($1,354,561 / $2,261,228). This has to do with the fact that Green Mountain experienced an increase in equity and a decrease in liabilities during Green Mountain’s debt to equity ratios for both years indicate a fairly low risk position. Debt to equity ratio = Total liabilities / Total equity Debt to equity ratio = $1,125,978 / $2,635,570 Debt to equity ratio = 0.43 (rounded) © Pearson Education, Inc.

Learning Objective 7 Use time value of money to compute the present value of future amounts (Appendix 12A) © Pearson Education, Inc.

What Is the Time Value of Money, and How Is the Present Value of a Future Amount Calculated? A dollar received today is worth more than a dollar to be received in the future. The fact that invested cash earns interest over time is called the time value of money. The time value of money is used to determine the present value of a bond, its market price. A dollar received today is worth more than a dollar to be received in the future because you can invest today’s dollar and earn additional interest, so you’ll have more cash next year. The time value of money concept explains why we would prefer to receive cash sooner rather than later. © Pearson Education, Inc.

Time Value of Money Concepts
The time value of money depends on these key factors: The principal amount (p): The amount of the investment or borrowing, either as a lump sum or an annuity The number of periods (n): The length of time The interest rate (i): The percentage earned or invested The time value of money depends on these key factors: The principal amount (p) The number of periods (n) The interest rate (i) The principal (p) refers to the amount of the investment or borrowing. We state the principal as either a single lump sum or an annuity. An annuity is a stream of equal cash payments made at equal time intervals. For example, $100 cash received per month for 12 months is an annuity. The number of periods (n) is the length of time from the beginning of the investment or borrowing until termination. All else being equal, the shorter the investment or borrowing period, the lower the total amount of interest earned or paid. The interest rate (i) is the percentage earned on the investment or paid on the borrowing and can be stated annually or in days, months, or quarters. The interest rate must reflect the number of time periods in the year. © Pearson Education, Inc.

Simple Interest Versus Compound Interest
Simple interest means that interest is calculated only on the principal amount. Compound interest means that interest is calculated on the principal and all previously earned interest. Simple interest is interest calculated only on the principal amount. Compound interest is interest calculated on the principal and on all previously earned interest. Compound interest assumes that all interest earned will remain invested and earn additional interest at the same interest rate. © Pearson Education, Inc.

Simple Interest Versus Compound Interest
Exhibit 12A-1 compares simple interest at 6% on a five-year, $10,000 investment with interest compounded yearly (rounded to the nearest dollar). As you can see, the amount of compound interest earned yearly grows as the base on which it is calculated (principal plus cumulative interest to date) grows. Over the life of the investment, the total amount of compound interest is more than the total amount of simple interest. Most investments yield compound interest, so we assume compound interest, rather than simple interest, for this chapter. © Pearson Education, Inc.

Present Value of a Lump Sum
How much would you need to invest today (in the present time) to have $13,383 in five years if the interest rate is 6%? Use the PV factor from the table Present Value of $1 (Appendix B, Table B-1). The present value of $1 is found in Appendix B, Table B-1 and is used to calculate the value today of one future amount (a lump sum). The data in each table, known as present value factors, are for an investment (or loan) of $1. To find the present value of an amount other than $1, multiply the present value factor by the future amount. We determine the PV factor from the table labeled Present Value $1 (Appendix B, Table B-1). We use this table for lump sum amounts. We look down the 6% column and across the 5 periods row and find the PV factor is If approximately $9,997 is invested today at 6% for five years, at the end of five years, the investment will grow to $13,383. © Pearson Education, Inc.

Present Value of an Annuity
A series of equal payments over equal intervals (years) is an annuity. Assume instead of receiving a lump sum at the end of five years, you will receive $2,000 at the end of each year. Let’s now assume that instead of receiving a lump sum at the end of the five years, you will receive $2,000 at the end of each year. This is a series of payments ($2,000) over equal intervals (years), so it is an annuity. How much would you have to invest today to receive these payments, assuming an interest rate of 6%? We determine the annuity PV factor from the table labeled Present Value of Ordinary Annuity of $1 (Appendix B, Table B-2). We use this table for annuities. We look down the 6% column and across the 5 periods row and find the annuity PV factor is Let’s verify the calculation. The chart shows that the initial investment of $8,424 is invested for one year, earning $505 in interest. At the end of that period, the first withdrawal of $2,000 takes place, leaving a balance of $6,929, calculated as $8,424 plus $505 less $2,000. At the end of the five years, the ending balance is $0, proving that the present value of the $2,000 annuity is $8,424. © Pearson Education, Inc.

Present Value of Bonds Payable
We can use the present value of a lump sum and present value of an annuity concepts to determine the selling price of a bond. The present value of a bond—its market price—is the sum of: The present value of the principal amount to be paid at maturity The present value of the future stated interest payments, an annuity We can use what we have just learned about the present value of a lump sum and present value of an annuity to calculate the present value of bonds payable. The present value of a bonds—its market price—is the sum of: The present value of the principal amount to be paid at maturity, a single amount (present value of a lump sum) The present value of the future stated interest payments, an annuity because it occurs in equal amounts over equal time periods (present value of an annuity) © Pearson Education, Inc.

Present Value of a Bonds Payable Issued at a Discount
Assume the following information: Smart Touch Learning issues $100,000 of five-year, 9% bonds that pay interest semiannually. The market interest rate is 10%. Maturity payment = $100,000 Periodic interest = $4,500 Interest rate = 10% (5% semiannually) Number of periods = 10 (payments twice a year for 5 years) Let’s compute the present value of Smart Touch Learning’s 9%, five-year bonds. The face value of the bonds is $100,000, and they pay (9% × 6/12), or 4.5% stated interest, semiannually. At issuance, the annual market interest rate is 10% (5% semiannually). Therefore, the market interest rate for each of the 10 semiannual periods is 5%. We use 5% to compute the present value (PV) of the maturity value and the PV of the stated interest. The present value of these bonds is $96,149. © Pearson Education, Inc.

Present Value of a Bonds Payable Issued at a Discount
The present value of the principal is $61,400 (the face value of $100,000 times the PV factor of 0.614). The present value of the interest payments, an annuity, is $34,749 (($100,000 × 0.09 × 6/12) × 7.722). The present value of the bonds is the sum of the present value of the principal plus the present value of the interest payments: $96,149 ($61,400 + $34,749). © Pearson Education, Inc.

Present Value of a Bonds Payable Issued at a Premium
Assume the following information: Smart Touch Learning issues $100,000 of five-year, 9% bonds that pay interest semi-annually. The market interest rate is 10%. Maturity payment = $100,000 Periodic interest = $4,500 Interest rate = 8% (4% semiannually) Number of periods = 10 (payments twice a year for 5 years) Let’s compute the present value of Smart Touch Learning’s 9%, five-year bonds. The face value of the bonds is $100,000, and they pay (9% × 6/12), or 4.5% stated interest, semiannually. At issuance, the annual market interest rate is 8% (4% semiannually). Therefore, the market interest rate for each of the 10 semiannual periods is 4%. We use 4% to compute the present value (PV) of the maturity value and the PV of the stated interest. © Pearson Education, Inc.

Present Value of a Bonds Payable Issued at a Premium
Let’s consider a premium price for the Smart Touch Learning bonds. The present value of the principal is $67,600 (the face value of $100,000 times the PV factor of 0.676). The present value of the interest payments, an annuity, is $36,500 (($100,000 × 0.09 × 6/12) × 8.111). The present value of the bonds is the sum of the present value of the principal plus the present value of the interest payments: $104,100 ($67,600 + $36,500). © Pearson Education, Inc.

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

How Are Bonds Payable Accounted for Using the Effective-Interest Amortization Method? Earlier we used a straight-line approach for amortizing the discount and determining interest expense. The effective-interest amortization method computes interest expense based on the carrying amount of the bond and the market rate at issuance. A more precise way to amortize bonds is called the effective-interest amortization method. The effective-interest amortization method is an amortization model that calculates interest expense based on the current carrying amount of the bond and the market interest rate at issuance, then amortizes the difference between the cash interest payment and calculated interest expense as a decrease to the discount or premium. Generally Accepted Accounting Principles require that interest expense be measured using the effective-interest amortization method unless the straight-line amounts are similar. Total interest expense over the life of the bonds is the same under both methods; however, interest expense each year is different between the two methods. © Pearson Education, Inc.

Effective-Interest Amortization for a Bond Discount
Smart Touch Learning issues $100,000 of 9% bonds at a time when the market rate of interest is 10%. The interest expense is calculated using the carrying amount of the bonds and the market interest rate. Assume that Smart Touch Learning issues $100,000 of 9% bonds at a time when the market rate of interest is 10%. These bonds mature in five years and pay interest semiannually, so there are 10 semiannual interest payments. As you just saw in Appendix 12A, the issue price of the bonds is $96,149, and the discount on these bonds is $3,851 ($100,000 ‒ $96,149). When using the effective-interest amortization method, the amount of the interest expense is calculated using the carrying amount of the bonds and the market interest rate. The interest payment is calculated using the face value of the bonds and the stated interest rate. The amount of discount amortization is the excess of the calculated interest expense over the interest payment. © Pearson Education, Inc.

Exhibit 12B-1 shows how to calculate interest expense by using the effective-interest amortization method. © Pearson Education, Inc.

Using the discount amortization table, record Smart Touch Learning’s first interest payment on June 30. When recording the interest payment for the bonds payable, the accounts debited and credited under the effective-interest amortization method and the straight-line amortization method are the same. Only the amounts differ. The journal entry requires a debit to Interest Expense of $4,807, a credit to Cash of $4,500, and a credit to Discount on Bonds Payable of $307. © Pearson Education, Inc.

Effective-Interest Amortization of a Bond Premium
Smart Touch Learning issues $100,000 of 9% bonds at a time when the market rate of interest is 8%. The interest expense is calculated using the carrying amount of the bonds and the market interest rate, similar to the method used for discounted bonds. Smart Touch Learning may issue its bonds at a premium. Assume that Smart Touch Learning issues $100,000 of five-year, 9% bonds when the market rate of interest is 8%. The bonds’ issue price is $104,100, and the premium is $4,100. When a bond is issued at a premium, the interest expense calculation using the effective-interest amortization method uses the carrying amount of the bonds and the market interest rate, as shown with a discounted bond. The calculation of premium amortization is calculated as the difference between the cash paid and the calculated interest expense. © Pearson Education, Inc.

Exhibit 12B-2 provides the amortization schedule using the effective-interest amortization method for Smart Touch Learning. © Pearson Education, Inc.

Using the premium amortization table, record Smart Touch Learning’s first interest payment on June 30. The journal entry requires a debit to Interest Expense of $4,164, a debit to Premium on Bonds Payable of $366, and a credit to Cash of $4,500. Regardless of which method is used, the total amount of cash paid and total interest expense are the same. © Pearson Education, Inc.

Chapter 12 Long-Term Liabilities

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Chapter 12 Long-Term Liabilities

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