long-term liabilities

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Long-Term LiabilitiesLong-Term Liabilities

Chapter 15Chapter 15

ACCT 202

WEEK 4

ACCT 202

WEEK 4

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Bonds: An IntroductionBonds: An Introduction• A bond is an interest bearing long-

term note payable.• Bonds are groups of notes payable

issued to multiple lenders called bondholders.

– principal– interest rate– interest payment dates

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Types of BondsTypes of Bonds

Term bonds

Serial bonds

Secured or mortgage bonds

Debenture bonds

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Bond PricesBond Prices

• A bond is quoted as a percent of its face value.

• A quote of 99½ means that a $1,000 bond sells for $1,000 × 0.995, or $995.

• Bond prices are affected by...– time to maturity.– credit rating of issuer.– interest rate.

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Present ValuePresent Value• The amount invested today receives a

greater amount at a future date which is called the present value of a future amount.

• It depends upon...– the amount of the future receipt.– the length of time to the future receipt.– interest rate for the period.

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Issuing Bonds PayableIssuing Bonds Payableto Borrow Moneyto Borrow Money

• On January 1, Granite Corp. issued $1,000,000 of 10%, 10-year bonds.

January 1Cash 1,000,000

Bonds Payable 1,000,000To issue 10%, 10-year bonds

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Issuing Bonds PayableIssuing Bonds Payableto Borrow Moneyto Borrow Money

• What is the entry for the interest payment of July 1?

• $1,000,000 × 10% × 1/2 = $50,000

July 1Interest Expense 50,000

Cash 50,000To record semiannual interest

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Issuing Bonds and Notes Payable Issuing Bonds and Notes Payable Between Interest DatesBetween Interest Dates

• On March 31, Granite Corp. sells $1,0000,000 of 10%, 10-year bonds dated January 1.

March 31Cash 1,025,000

Bonds Payable 1,000,000Interest Payable 25,000

To issue 10%, 10-year bonds at par threemonths after original issue date

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Issuing Bonds and Notes Payable Issuing Bonds and Notes Payable Between Interest DatesBetween Interest Dates

• What is the July 1 interest expense?• $1,000,000 × 10% × 1/4 = $25,000

June 30Interest Expense 25,000Interest Payable 25,000

Cash 50,000To pay semiannual interest

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A 10-year, $1,000,000 bond issue is sold byGranite Corp. at 99¼ on January 1.

The contract rate of interest is 10% (20 periods).

Cash 992,500Discount onBonds Payable 7,500

Bonds Payable 1,000,000To issue 10%, 10-year bonds at a discount

Issuing Bonds PayableIssuing Bonds Payableat a Discountat a Discount

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Account for bonds payable

Transactions.

Objective 1Objective 1

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Straight-Line AmortizationStraight-Line Amortizationof Bond Discountof Bond Discount

• This method amortizes the bond discount by dividing it into equal amounts for each interest period.

• Granite Corp. would amortize the $7,500 discount over 20 periods.

• $7,500 ÷ 20 = $375 per period

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July 1Interest Expense 50,375

Cash 50,000Discount on Bonds Payable 375

Paid semiannual interest and amortized discounton bonds payable

Straight-Line AmortizationStraight-Line Amortizationof Bond Discountof Bond Discount

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Granite Corp. sold a 10%, 10-year (20 periods),$1,000,000 bond issue at a price of 101 on Jan. 1.

Cash 1,010,000Bonds Payable 1,000,000Premium on Bonds Payable 10,000

Issued bonds payable at a premium

Issuing Bonds PayableIssuing Bonds Payableat a Premiumat a Premium

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Issuing Bonds PayableIssuing Bonds Payableat a Premiumat a Premium

Granite Balance Sheet(immediately after issuance of the bonds)

Long-term liabilities:Bonds payable, 10%, due 20xx $1,000,000Premium of bonds payable 10,000

$1,010,000

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July 1Interest Expense 40,500Premium on Bonds Payable 500

Cash 50,000Paid semiannual interest and amortizedpremium on bonds payable

Straight-Line AmortizationStraight-Line Amortizationof Bond Premiumof Bond Premium

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Granite Balance Sheet (December 31)

Long-term liabilities:Bonds payable, 10%, due 20xx $1,000,000Premium on bonds payable 9,000

$1,009,000

Reporting Bonds PayableReporting Bonds Payable

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Adjusting Entries for Interest Adjusting Entries for Interest ExpenseExpense

• San Antonio Corporation issued $150,000 of its 8%, 10-year bonds at a $3,000 discount on October 1, 2002.

• The interest payments occur on March 31 and September 30 each year.

• San Antonio closes its books on December 31.

• What accounts are involved?

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• Interest Payable: $150,000 × 8% × 3/12 = $3,000

• Discount Amortization: $3,000 ÷ 10 × 3/12 = $75

• Interest Expense: $3,000 + $75 = $3,075

• What is the adjusting entry?

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December 31, 2002Interest Expense 3,075

Interest Payable 3,000Discount on Bonds Payable 75

Accrued three months’ interest andamortized discount on bonds payable

What is the entry on March 31, 2003?

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March 31, 2003Interest Expense 3,075Interest Payable 3,000

Cash 6,000Discount on Bonds Payable 75

Paid semiannual interest, part of whichwas accrued, and amortized three months’discount on bonds payable

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Measure interest expense bythe effective-interest

method.


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Effective-Interest MethodEffective-Interest Methodof Amortizationof Amortization

• The effective-interest method keeps interest expense at the same percentage over any bond’s life.

• Generally accepted accounting principles require that interest expense be measured using the effective-interest method.

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Effective-Interest Method:Effective-Interest Method:Bond DiscountBond Discount

• Assume that Granite Corp. issues $100,000 of its 9% bonds at a discount of $3,851, at a time when the market rate of interest is 10%.

• These bonds mature in five years and pay interest semiannually.

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Cash 96,149Discount on Bonds Payable 3,851

Bonds Payable 100,000To issue 10%, 10-year bonds at a discount

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• What is the interest expense at the end of period one?

• $96,149 × 10% × 6/12 = $4,807• What is the interest payment at the

end of period one?• $100,000 × 9% × 6/12 = $4,500• $4,807 – $4,500 = $307 amortization

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End of Carrying Interest CashPeriod Value Expense Paid AmortizationIssue 96,149Date 1 96,456 4,807 4,500 307 2 96,779 4,823 4,500 323 3 97,118 4,839 4,500 339 4 97,474 4,856 4,500 356

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Effective-Interest Method:Effective-Interest Method:Bond PremiumBond Premium

• Assume the Granite Corp. issues a $100,000, 5-year, 9% bond to yield 8%, at a premium of $4,100.

• The first period interest expense is computed as follows:

• $104,100 × 8% × 6/12 = $4,164

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Effective-Interest Method:Effective-Interest Method:Bond PremiumBond Premium

End of Carrying Interest CashPeriod Value Expense Paid AmortizationIssue 104,100Date 1 103,764 4,164 4,500 336 2 103,415 4,151 4,500 349 3 103,052 4,137 4,500 363 4 102,674 4,122 4,500 378

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Account for retirement and conversion

of bonds payable.


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Retirement of Bonds Retirement of Bonds PayablePayable

• To retire a bond early, the issuer can ...– purchase the bonds in the open market, or– exercise a call option.• A call option is a clause that allows the

bond issuer to redeem the bonds at a specified price (usually a few points over par) on or after a specified date.

• The journal entry is the same in either case.

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Retirement of Bonds PayableRetirement of Bonds Payable Example Example

$500,000 of 12% bonds with an unamortized premiumof $20,000 are purchased for $498,000 and retired.

Bonds Payable 500,000Premium of Bonds Payable 20,000

Cash 498,000 Gain on Retirement of Bonds 22,000Retired bonds payable

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Convertible Bonds and Convertible Bonds and NotesNotes

• Convertible bonds and notes give the holder the option of exchanging the bond for a specified number of shares of common stock.

• If a bond issue or a note payable is converted into common stock, stockholders’ equity is increased by the carrying amount of the bonds converted.

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Current Portion of Long-Current Portion of Long-Term DebtTerm Debt

• Serial bonds and serial notes are payable in installments.

• The portion payable within one year is a current liability.

• The remaining debt is long term.

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Report Liabilities on the Balance Sheet


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Report Liabilities on the Report Liabilities on the Balance SheetBalance Sheet

• Notes payable and bonds payables are reported as liabilities on the balance sheet as either current or long-term.

Current Liabilities: Notes payable, current………$200,000Long-term Liabilities

Notes payable, long-term…… $300,000

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Show the advantages anddisadvantages of

borrowing.


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•Equity financing creates no liabilities and no interest burden.•It is less risky to the issuing corporation.•It may dilute ownership interest of existing shareholders.

•Debt financing does not dilute control.•It usually results in higher earnings per share.•It reduces total net income and may impose financial restrictions on the company.

Issuing Bonds versus StockIssuing Bonds versus Stock

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Advantage of Issuing BondsAdvantage of Issuing Bondsversus Stock Exampleversus Stock Example

• Suppose that Granite Corp., with net income of $300,000 and with 100,000 shares of common stock outstanding, needs $500,000 for expansion.

• Money can be borrowed at 10% interest.

• The income tax rate is 40%.

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• 50,000 shares of common stock can be issued for $500,000.

• Management believes that the new cash can be invested in operations to earn income of $200,000 before interest and taxes.

• Should the company borrow the money or issue additional common stock?

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Borrow $500,000

Expected net income on the new project $200,000Interest expense – 50,000Project income before taxes $150,000Income tax expense – 60,000Project net income $ 90,000Net income before expansion $300,000Total income $390,000

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Issue 50,000 shares of common stock at $10 per share

Expected net income on the new project $200,000Income tax expense – 80,000Project net income $120,000Net income before expansion $300,000Total income $420,000

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Borrow $500,000:$390,000 ÷ 100,000 = $3.90 earnings per share

Issue $500,000 of common stock:$420,000 ÷ 150,000 = $2.80 earnings per share

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Bonds that give bondholders the right Bonds that give bondholders the right to taketo take specified assets of the issuer if specified assets of the issuer if the issuer fails to pay principal or the issuer fails to pay principal or interest are calledinterest are called

• Debenture bonds• Serial bonds• Secured bonds• Term bonds

Revısıon questıonsRevısıon questıons

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Answer: 3Answer: 3

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Bonds that mature at a single Bonds that mature at a single specified future date are calledspecified future date are called• Debenture bonds• Serial bonds• Secured bonds• Term bonds

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Answer: 4Answer: 4

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A $1,000 face value bond with A $1,000 face value bond with a quoted price of 97 would sell a quoted price of 97 would sell

forfor

• $97• $300• $970• $1,000

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Answer: $970 ($1,000 x .97)Answer: $970 ($1,000 x .97)

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If the market interest rate is If the market interest rate is greater than the stated interest greater than the stated interest

rate, bonds will sell atrate, bonds will sell at

• face value.• a discount.• a premium.

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Answer: 2 Investors demand a Answer: 2 Investors demand a higher return than what the higher return than what the

company is paying. They would company is paying. They would pay less than the face amount pay less than the face amount

(discount) in order to effectively (discount) in order to effectively earn the market rate of interest.earn the market rate of interest.

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If the market interest rate is 8%, a If the market interest rate is 8%, a $1,000, 10%, 10-year bond, that $1,000, 10%, 10-year bond, that pays interest semiannually would pays interest semiannually would

sell forsell for• less than face value.• equal to face value.• greater than face value.• cannot be determined.

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Answer: 3 The bond would sell at Answer: 3 The bond would sell at a premium (greater than face a premium (greater than face

value) because investors would be value) because investors would be willing to pay more in order to willing to pay more in order to

receive the higher interest receive the higher interest payments.payments.

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What kind of account is What kind of account is Discount on Bonds Payable?Discount on Bonds Payable?

• Asset• Contra asset• Contra liability• Stockholder’s equity

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Answer: 3

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The ledger of Gant Company The ledger of Gant Company shows Bonds Payable of shows Bonds Payable of

$100,000 and Premium on $100,000 and Premium on Bonds Payable of $10,000. Bonds Payable of $10,000. What is the amount of the What is the amount of the

carrying value of the bonds on carrying value of the bonds on the balance sheet?the balance sheet?

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Answer: $110,000Answer: $110,000Bonds PayableBonds Payable $100,000$100,000Premium on bonds payablePremium on bonds payable

10,00010,000$110,000$110,000

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Corey Company issues $100,000, Corey Company issues $100,000, 10-year bonds payable for cash of 10-year bonds payable for cash of

$94,000. The stated rate of $94,000. The stated rate of interest is 10% and is paid interest is 10% and is paid

semiannually. Corey uses the semiannually. Corey uses the straight-line method to amortize straight-line method to amortize

bond discounts or premiums. How bond discounts or premiums. How much interest expense will Corey much interest expense will Corey

recognize every 6 months?recognize every 6 months?

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Answer: $5,300Answer: $5,300Cash interest payment = Cash interest payment =

$100,000 x .10 x ½ =$100,000 x .10 x ½ = $5,000$5,000Bond discount amortization = Bond discount amortization =

$6,000 ÷ 20 interest payment $6,000 ÷ 20 interest payment periods = periods = 300300Interest ExpenseInterest Expense $5,300$5,300

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If bonds with a face value of $100,000 If bonds with a face value of $100,000 and a carrying value of $80,000 are and a carrying value of $80,000 are

retired by paying cash of $75,000, the retired by paying cash of $75,000, the entry to record the sale would includeentry to record the sale would include

• Credit to Discount on Bonds Payable• Credit to Premium on Bonds Payable• Debit to Gain on Retirement of Bonds• Debit to Retained Earnings

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Answer: 1Answer: 1

The entire entry would be:The entire entry would be:

Bonds payableBonds payable 100,000100,000 Discount on bonds payable Discount on bonds payable

20,00020,000 Cash Cash

75,00075,000 Gain on retirement of bonds Gain on retirement of bonds

5,0005,000

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Jennings Corp. has $10,000 of Jennings Corp. has $10,000 of convertible bonds payable convertible bonds payable

outstanding, with a bond premium of outstanding, with a bond premium of $2,000 also on the books. The $2,000 also on the books. The

bondholders convert the bonds into bondholders convert the bonds into stock. The bonds may be converted stock. The bonds may be converted into 4,000 shares of Jennings $1 par into 4,000 shares of Jennings $1 par common stock. The journal entry to common stock. The journal entry to record the conversion would include:record the conversion would include:

• Credit Paid in Capital in Excess of Par• Credit Premium on Bonds Payable• Debit Loss on Conversion of Bonds• Debit Treasury Stock

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Answer: 1The journal entry would be:Bonds Payable 10,000Premium on Bonds Payable 2,000 Common stock 4,000 Paid in Capital in Excess of Par 8,000

long-term liabilities

Documents

bonds payable1

premium of bonds payable

issued bonds payable

bonds payabletransactions

bonds payable 500cash50

premiumissuing bonds

bond issue

discount onbonds payable