15 Long-Term Liabilities Learning Objectives

15 Long-Term Liabilities Learning Objectives 1 2 3 4
Describe the major characteristics of bonds. 1 Explain how to account for bond transactions. 2 Explain how to account for long-term notes payable. 3 Discuss how long-term liabilities are reported and analyzed. 4

1 Describe the major characteristics of bonds.
LEARNING OBJECTIVE 1 Long-term liabilities are obligations that are expected to be paid after one year. Bonds are a form of interest-bearing notes payable. Sold in small denominations (usually $1,000 or multiples of $1,000). Attract many investors. Corporation issuing bonds is borrowing money. Person who buys the bonds (the bondholder) is investing in bonds. LO 1

Types of Bonds LO 1

Bonds Issuing Procedures
State laws grant corporations the power to issue bonds. Board of directors and stockholders must approve bond issues. Board of directors must stipulate number of bonds to be authorized, total face value, and contractual interest rate. Bond terms set forth in legal document known as a bond indenture. Bond certificate, typically a $1,000 face value. LO 1

Bonds Issuing Procedures Represents a promise to pay:
sum of money at designated maturity date, plus periodic interest at a contractual (stated) rate on the maturity amount (face value). Interest payments usually made semiannually. Issued to obtain large amounts of long-term capital. Investment company sells the bonds for the issuing company. LO 1

Illustration 15-1 Bond certificate LO 1

Determining the Market Value of a Bond
Current market price (present value) is a function of the three factors: dollar amounts to be received, length of time until the amounts are received, and market rate of interest. The market interest rate is the rate investors demand for loaning funds. LO 1

Illustration: Assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in five years, with interest payable annually at year-end. The purchaser of the bonds would receive the following two types of cash payments: (1) principal of $100,000 to be paid at maturity, and (2) five $9,000 interest payments ($100,000 x 9%) over the term of the bonds. Illustration 15-2 Time diagram depicting cash flows LO 1

Illustration 15-2 The current market price of a bond is equal to the present value of all the future cash payments promised by the bond. Illustration 15-3 Computing the market price of bonds LO 1

DO IT! 1 Bond Terminology True True False True False
State whether each of the following statements is true or false. _______ 1. Mortgage bonds and sinking fund bonds are both examples of secured bonds. _______ 2. Unsecured bonds are also known as debenture bonds. _______ 3. The stated rate is the rate investors demand for loaning funds. _______ 4. The face value is the amount of principal the issuing company must pay at the maturity date. _______ 5. The market price of a bond is equal to its maturity value. True True False True False LO 1

2 Explain how to account for bond transactions.
LEARNING OBJECTIVE 2 Corporation records bond transactions when it issues (sells), redeems (buys back) bonds, and when bondholders convert bonds into common stock. NOTE: If bondholders sell their bond investments to other investors, the issuing company receives no further money on the transaction, nor does the issuing company journalize the transaction. LO 2

Bond Contractual Interest
Accounting for Bond Transactions Issue at Face Value, Discount, or Premium? Illustration 15-4 Interest rates and bond prices Bond Contractual Interest Rate 10% Run slide show to reveal “Bonds Sell at.” LO 2

Accounting for Bond Transactions
Question The rate of interest investors demand for loaning funds to a corporation is the: contractual interest rate. face value rate. market interest rate. stated interest rate. LO 2

Accounting for Bond Transactions
Question Karson Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that: the contractual interest rate exceeds the market interest rate. the market interest rate exceeds the contractual interest rate. the contractual interest rate and the market interest rate are the same. no relationship exists between the two rates. LO 2

Issuing Bonds at Face Value
Illustration: On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is: Jan. 1 Cash 100,000 Bonds Payable 100,000 LO 2

Illustration: On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable annually on January 1. At December 31, 2017, Candlestick recognizes interest expense incurred with the following entry. Assume monthly accruals have not been made. Dec. 31 Interest Expense 10,000 Interest Payable 10,000 LO 2

Illustration: On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable annually on January 1. Candlestick records the payment on January 1, 2018, as follows. Jan. 1 Interest Payable 10,000 Cash 10,000 LO 2

Issuing Bonds at a Discount
Illustration: On January 1, 2017, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $98,000 (98% of face value). Interest is payable annually January 1. The entry to record the issuance is: Jan. 1 Cash 98,000 Discount on Bonds Payable 2,000 Bonds Payable 100,000 LO 2

Statement Presentation Illustration 15-5 Statement presentation of discount on bonds payable Carrying value or book value Sale of bonds below face value (discount) = total cost of borrowing > interest paid. Reason: Borrower is required to pay the bond discount at the maturity date. Therefore, the bond discount is considered to be a increase in the cost of borrowing. LO 2

Total Cost of Borrowing Illustration 15-6 OR Illustration 15-7 LO 2

Illustration 15-8 Amortization of bond discount LO 2

Question Discount on Bonds Payable: has a credit balance. is a contra account. is added to bonds payable on the balance sheet. increases over the term of the bonds. LO 2

Issuing Bonds at a Premium
Illustration: On January 1, 2017, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $102,000 (102% of face value). Interest is payable annually January 1. The entry to record the issuance is: Jan. 1 Cash 102,000 Bonds Payable 100,000 Premium on Bonds Payable 2,000 LO 2

Statement Presentation Illustration 15-9 Statement presentation of discount on bonds payable Sale of bonds above face value (premium) = total cost of borrowing < interest paid. Reason: Borrower is not required to pay the bond premium at the maturity date of the bonds. Therefore, the bond premium is considered to be a reduction in the cost of borrowing. LO 2

Total Cost of Borrowing Illustration 15-10 OR Illustration 15-11 LO 2

Illustration 15-12 Amortization of bond premium LO 2

DO IT! 2a Bond Issuance Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance. Solution (a) Cash 189,000 Discount on Bonds Payable 11,000 Bonds Payable 200,000 (b) Long-term liabilities Bonds payable $200,000 Less: Discount on bonds payable 11,000 $189,000 LO 2

REDEEMING BONDS AT MATURITY
Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows: Jan. 1 Bonds Payable 100,000 Cash 100,000 LO 2

REDEEMING BONDS BEFORE MATURITY
When bonds are redeemed before maturity, it is necessary to: eliminate carrying value of bonds at redemption date; record cash paid; and recognize gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less any remaining bond discount or plus any remaining bond premium at the redemption date. LO 2

Question When bonds are redeemed before maturity, the gain or loss on redemption is the difference between the cash paid and the: carrying value of the bonds. face value of the bonds. original selling price of the bonds. maturity value of the bonds. LO 2

Illustration: Assume Candlestick, Inc. has sold its bonds at a premium. At the end of the fourth period, Candlestick retires these bonds at 103 after paying the annual interest. The carrying value of the bonds at the redemption date is $100,400. Candlestick makes the following entry to record the redemption at the end of the fourth interest period (January 1, 2021): Jan. 1 Bonds Payable 100,000 Premium on Bonds Payable 400 Loss on Bond Redemption 2,600 Cash 103,000 LO 2

CONVERTING BONDS INTO COMMON STOCK
Until conversion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option. Upon conversion, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized. LO 2

Illustration: On July 1, Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion: July 1 Bonds Payable 100,000 Common Stock (2,000 x $10) 20,000 Paid-in Capital in Excess of Par— Common Stock 80,000 LO 2

Question When bonds are converted into common stock: a gain or loss is recognized. the carrying value of the bonds is transferred to paid-in capital accounts. the market price of the stock is considered in the entry. the market price of the bonds is transferred to paid-in capital. LO 2

People, Planet, and Profit Insight
Unilever How About Some Green Bonds? Unilever recently began producing popular frozen treats such as Magnums and Cornettos, funded by green bonds. Green bonds are debt used to fund activities such as renewable- energy projects. In Unilever’s case, the proceeds from the sale of green bonds are used to clean up the company’s manufacturing operations and cut waste (such as related to energy consumption). The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green- bond proceeds. These standardized disclosures provide transparency as to how these bonds are used and their effect on overall profitability. Investors are taking a strong interest in these bonds. Investing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes. The disclosures of how companies are using the bond proceeds help investors to make better financial decisions. Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p. C5. LO 2

DO IT! 2b Bond Redemption R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds. Solution Bonds Payable 500,000 Discount on Bonds Payable 4,000 Gain on Bond Redemption 6,000 Cash ($500,000 x 98%) 490,000 LO 2

Long-Term Notes Payable
Explain how to account for long-term notes payable. LEARNING OBJECTIVE 3 Long-Term Notes Payable May be secured by a mortgage that pledges title to specific assets as security for a loan. Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of interest on the unpaid balance of the loan and a reduction of loan principal. Companies initially record mortgage notes payable at face value. LO 3

Illustration: Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, The terms provide for semiannual installment payments of $50,926 (not including real estate taxes and insurance). Illustration 15-13 Mortgage installment payment schedule LO 3

Illustration: Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, The terms provide for semiannual installment payments of $50,926 (not including real estate taxes and insurance). Prepare the entries to record the mortgage and first payment. Dec. 31 Cash 500,000 Mortgage Payable 500,000 Dec. 31 Interest Expense 40,000 Mortgage Payable 10,926 Cash 50,926 LO 3

Question Each payment on a mortgage note payable consists of: interest on the original balance of the loan. reduction of loan principal only. interest on the original balance of the loan and reduction of loan principal. interest on the unpaid balance of the loan and reduction of loan principal. LO 3

DO IT! 3 Long-Term Notes Cole Research issues a $250,000, 6%, 20-year mortgage note to obtain needed financing for a new lab. The terms call for annual payments of $21,796 each. Prepare the entries to record the mortgage loan and the first payment. Solution Cash 250,000 Mortgage Payable 250,000 Interest Expense ($250,000 x 6%) 15,000* Mortgage Payable 6,796 Cash 21,796 LO 3

Discuss how long-term liabilities are reported and analyzed.
LEARNING OBJECTIVE 4 Illustration 15-14 Balance sheet presentation of long-term liabilities Presentation Companies report the current maturities of long-term debt under current liabilities if they are to be paid within one year or the operating cycle, whichever is longer. LO 4

Use of Ratios Two ratios that provide information long-run solvency and the ability to meet interest payments as they come due are: Debt to Assets Ratio Times Interest Earned LO 4

Use of Ratios Illustration: Kellogg Company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. Illustration 15-15 Debt to assets ratio The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations. LO 4

Use of Ratios Illustration: Kellogg Company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. Illustration 15-16 Times interest earned Times interest earned indicates the company’s ability to meet interest payments as they come due. LO 4

Debt and Equity Financing
Illustration 15-17 Advantages of bond financing over common stock LO 4

Debt and Equity Financing
Illustration: Microsystems, Inc. is considering two plans for financing the construction of a new $5 million plant. It is considering two alternatives for raising an additional $5 million: Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 8% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%. Illustration 15-18

Lease Liabilities and Off-Balance-Sheet Financing
A lease is a contractual arrangement between a lessor (owner of the property) and a lessee (renter of the property). Illustration 15-19 LO 4

Lease Liabilities Operating Lease Capital Lease
The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do. Operating Lease Capital Lease Journal Entry: Rent Expense xxx Cash xxx Journal Entry: Leased Equipment xxx Lease Liability xxx A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only noncancellable leases may be capitalized). LO 4

CAPITAL LEASES To capitalize a lease, one or more of four criteria must be met: Transfers ownership to the lessee. Contains a bargain purchase option. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property. LO 4

CAPITAL LEASES Illustration: Gonzalez Company decides to lease new equipment. The lease period is four years; the economic life of the leased equipment is estimated to be five years. The present value of the lease payments is $190,000, which is equal to the fair market value of the equipment. There is no transfer of ownership during the lease term, nor is there any bargain purchase option. Instructions: What type of lease is this? Explain. Prepare the journal entry to record the lease. LO 4

CAPITAL LEASES Capitalization Criteria: NO NO YES - PV and FMV
Illustration: (a) What type of lease is this? Explain. Capitalization Criteria: Transfer of ownership Bargain purchase option Lease term => 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property Capital Lease? NO NO Lease term 4 yrs. Economic life 5 yrs. YES 80% YES - PV and FMV are the same. LO 4

CAPITAL LEASES Illustration: (b) Prepare the journal entry to record the lease. Leased Asset - Equipment 190,000 Lease Liability 190,000 The portion of the lease liability expected to be paid in the next year is a current liability. The remainder is classified as a long-term liability. LO 4

CAPITAL LEASES Question
The lessee must record a lease as an asset if the lease: transfers ownership of the property to the lessor. contains any purchase option. term is 75% or more of the useful life of the leased property. payments equal or exceed 90% of the fair market value of the leased property. LO 4

Investor Insight “Covenant-Lite” Debt
In many corporate loans and bond issuances, the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement. The creditors can then demand immediate repayment, or they can renegotiate the loan’s terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deeply into trouble. During the 1990s, most traditional loans specified between three to six covenants or “triggers.” In more recent years, when lots of cash was available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. Lending to weaker companies on easy terms is now common as investors’ appetite for higher-yielding debt grows stronger and the Federal Reserve keeps money flowing at ultralow rates. Since the 2008 financial crisis, companies have been able to borrow more without offering investors what were once considered standard protections against possible losses. Sources: Cynthia Koons, “Risky Business: Growth of ’Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2; and Katy Burne, “More Loans Come with Few Strings Attached,” Wall Street Journal June 12, 2014). LO 4

DO IT! 4 Lease Liability FX Corporation leases new equipment on December 31, The lease transfers ownership to FX at the end of the lease. The present value of the lease payments is $240,000. After recording this lease, FX has assets of $2,000,000, liabilities of $1,200,000, and stockholders’ equity of $800,000. (a) Prepare the entry to record the lease, and (b) compute the debt to assets ratio at year-end. (a) Leased Asset—Equipment 240,000 Lease Liability 240,000 (b) The debt to assets ratio = $1,200,000 ÷ $2,000,000 = 60%. LO 4

Amortizing Bond Discount
APPENDIX 15A: Apply the straight-line method of amortizing bond discount and bond premium. LEARNING OBJECTIVE 5 Amortizing Bond Discount Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1. Illustration 15C-2 Illustration 15A-2 Bond discount amortization schedule LO 5

Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1. The bond discount amortization for each interest period is $400 ($2,000 ÷ 5). Journal entry to record the first accrual of bond interest and the amortization of bond discount on December 31 as follows. Interest Expense ,400 Dec. 31 Discount on Bonds Payable Interest Payable 10,000 LO 5

Amortizing Bond Premium
Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000). Interest is payable on January 1. Illustration 15A-4 Bond premium amortization schedule LO 5

Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000. Interest is payable on January 1. The bond premium amortization for each interest period is $400 ($2,000 ÷ 5). Candlestick records the first accrual of interest on December 31 as follows. Interest Expense ,600 Dec. 31 Premium on Bonds Payable Interest Payable 10,000 LO 5

APPENDIX 15B: Apply the effective-interest method of amortizing bond discount and bond premium.
LEARNING OBJECTIVE 6 Under the effective-interest method, the amortization of bond discount or bond premium results in period interest expense equal to a constant percentage of the carrying value of the bonds. Required steps: Compute the bond interest expense. Compute the bond interest paid or accrued. Compute the amortization amount. LO 6

Effective-Interest Method
Required steps: Compute the bond interest expense. Compute the bond interest paid or accrued. Compute the amortization amount. Illustration 15B-1 Computation of amortization using effective-interest method LO 6

Effective-Interest Method
Amortizing Bond Discount Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2017, for $98,000, with interest payable each January 1. This results in a discount of $2,000. Illustration 15B-2 Illustration 15B-2 Bond discount amortization schedule LO 6

Illustration 15B-2 Bond discount amortization schedule Candlestick, Inc. records the accrual of interest and amortization of bond discount on December 31 as follows. Dec. 31 Interest Expense ,324 Interest Payable 10,000 Discount on Bonds Payable LO 6

Illustration 15B-2 Bond discount amortization schedule For the second interest period, at December 31, Candlestick makes the following adjusting entry. Dec. 31 Interest Expense ,358 Interest Payable 10,000 Discount on Bonds Payable LO 6

Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2017, for $102,000, with interest payable January 1. This results in a premium of $2,000. Illustration 15B-4 Bond premium amortization schedule LO 6

Illustration 15B-4 Bond premium amortization schedule The entry Candlestick makes on December 31 is: Dec. 31 Interest Expense ,669 Premium on Bonds Payable Interest Payable 10,000 LO 6

A Look at IFRS 7 Key Points
Compare the accounting for long-term liabilities under GAAP and IFRS. LEARNING OBJECTIVE 7 Key Points Similarities IFRS requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity. LO 7

A Look at IFRS Key Points
Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months. Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show long-term liabilities before current liabilities. The basic calculation for bond valuation is the same under GAAP and IFRS. In addition, the accounting for bond liability transactions is essentially the same between GAAP and IFRS. LO 7

A Look at IFRS Key Points
IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP allows use of the straight-line method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record: Cash 97,000 Bonds Payable 97,000 LO 7

A Look at IFRS Key Points Differences
The accounting for convertible bonds differs across IFRS and GAAP, Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity. LO 7

A Look at IFRS Key Points Differences
The IFRS leasing standard is IAS 17. Both Boards share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. However, GAAP for leases is much more “rules-based” with specific bright-line criteria (such as the “90% of fair value” test) to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more conceptual in its provisions. Rather than a 90% cut-off, it asks whether the agreement transfers substantially all of the risks and rewards associated with ownership. LO 7

A Look at IFRS Looking to the Future
The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. In addition to these projects, the FASB and IASB have also identified leasing as one of the most problematic areas of accounting. One of the first areas studied is, “What are the assets and liabilities to be recognized related to a lease contract?” Should the focus remain on the leased item or the right to use the leased item? This question is tied to the Boards’ joint project on the conceptual framework—defining an “asset” and a “liability.” LO 7

A Look at IFRS IFRS Self-Test Questions
The accounting for bonds payable is: essentially the same under IFRS and GAAP. differs in that GAAP requires use of the straight-line method for amortization of bond premium and discount. the same except that market prices may be different because the present value calculations are different between IFRS and GAAP. not covered by IFRS. LO 7

The leasing standards employed by IFRS: rely more heavily on interpretation of the conceptual meaning of assets and liabilities than GAAP. are more “rules based” than those of GAAP. employ the same “bright-line test” as GAAP. are identical to those of GAAP. LO 7

The joint projects of the FASB and IASB could potentially: change the definition of liabilities. change the definition of equity. change the definition of assets. All of the above. LO 7

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