mcgraw-hill/irwin 14-1 © the mcgraw-hill companies, inc., 2005 long-term liabilities chapter 14

McGraw-Hill/Irwin

14-1

© The McGraw-Hill Companies, Inc., 2005

Long-Term LiabilitiesChapter

1414

McGraw-Hill/Irwin

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Bonds do not affect stockholder control.Bonds do not affect stockholder control.Bonds do not affect stockholder control.Bonds do not affect stockholder control.

Interest on bonds is tax deductible.Interest on bonds is tax deductible.Interest on bonds is tax deductible.Interest on bonds is tax deductible.

Bonds can increase return on equity.Bonds can increase return on equity.Bonds can increase return on equity.Bonds can increase return on equity.

Advantages of BondsAdvantages of Bonds

A bond is its issuer’s written promise to pay an amount identified as the par value of the bond with interest.

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Original Expand by equity financing

Expand by bond financing

Income before interest expense

100,000 225,000 225,000

Interest expense / / (50,000)

Net income 100,000 225,000 175,000

Equity 1,000,000 1,500,000 1,000,000

Return on equity 10% 15% 17.5%

Invest 500,000 in a new project that can yield $125,000 income. Financing by equity or bond?

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Bonds require payment of both Bonds require payment of both periodic interest and par value at periodic interest and par value at

maturity.maturity.

Bonds require payment of both Bonds require payment of both periodic interest and par value at periodic interest and par value at

maturity.maturity.

Bonds can decrease return on Bonds can decrease return on equity when the company pays equity when the company pays more in interest than it earns on more in interest than it earns on

the borrowed funds.the borrowed funds.

Bonds can decrease return on Bonds can decrease return on equity when the company pays equity when the company pays more in interest than it earns on more in interest than it earns on

the borrowed funds.the borrowed funds.

Disadvantages of BondsDisadvantages of Bonds

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Types of BondsTypes of Bonds

Secured bonds have specific assets of the issuer pledged (or mortgaged) as collateral.

Unsecured bonds (debentures) are backed by the issuer’s general credit standing.

Convertible bonds can be exchanged for a fixed number of shares of the issuing corporation’s common stock.

Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.

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Bond Certificateat Par Value

Bond Certificateat Par Value

Bond Issue Date

Bond Selling Price

Corporation Investors

Basics of BondsBasics of Bonds

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Bond Issue Date

Bond Par Value

at Maturity Date

Bond Maturity

Date

Corporation Investors


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Bond Issue Date

Bond Interest Payments

Bond Interest PaymentsCorporation Investors

Interest Payment =

Bond Par Value Stated Interest Rate

Interest Payment =

Bond Par Value Stated Interest Rate


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. . .an investment firm called an underwriter. The underwriter sells the bonds to. . .

A company sells the bonds to. . .

. . . investors.

Bond Issuing ProceduresBond Issuing Procedures

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. . .an investment firm called an underwriter. The underwriter sells the bonds to. . .

A trustee monitors the bond issue.

A company sells the bonds to. . .

. . . investors

Bond Issuing ProceduresBond Issuing Procedures

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King Co. issues the following bonds on January 1, 2005King Co. issues the following bonds on January 1, 2005Par Value = $1,000,000Par Value = $1,000,000Stated Interest Rate = 10%Stated Interest Rate = 10%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2024 (20 years)Maturity Date = Dec. 31, 2024 (20 years)

King Co. issues the following bonds on January 1, 2005King Co. issues the following bonds on January 1, 2005Par Value = $1,000,000Par Value = $1,000,000Stated Interest Rate = 10%Stated Interest Rate = 10%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2024 (20 years)Maturity Date = Dec. 31, 2024 (20 years)

Issuing Bonds at ParIssuing Bonds at Par

Jan. 1 Cash 1,000,000 Bonds payable 1,000,000

Issues bonds at par

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$1,000,000 × 10% × ½ year = $50,000$1,000,000 × 10% × ½ year = $50,000This entry is made every six months until

the bonds mature.

$1,000,000 × 10% × ½ year = $50,000$1,000,000 × 10% × ½ year = $50,000This entry is made every six months until

the bonds mature.


The entry on June 30, 2005 to record the The entry on June 30, 2005 to record the first semiannual interest payment is . . .first semiannual interest payment is . . .

The entry on June 30, 2005 to record the The entry on June 30, 2005 to record the first semiannual interest payment is . . .first semiannual interest payment is . . .

June 30 Bond interest expense 50,000 Cash 50,000

Paid semi-annual interest

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On Dec. 31, 2024, the bonds mature, King On Dec. 31, 2024, the bonds mature, King Co. makes the following entry . . .Co. makes the following entry . . .

On Dec. 31, 2024, the bonds mature, King On Dec. 31, 2024, the bonds mature, King Co. makes the following entry . . .Co. makes the following entry . . .


The debt has now been extinguished.

Dec. 31 Bonds payable 1,000,000 Cash 1,000,000

Paid bond principal at maturity

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Bond Discount or PremiumBond Discount or Premium

Prepare the entry for Jan. 1, 2005 to record the following Prepare the entry for Jan. 1, 2005 to record the following bond issue by Rose Co. bond issue by Rose Co. Par Value = $1,000,000Par Value = $1,000,000Issue Price = 92.6405% of par valueIssue Price = 92.6405% of par valueStated Interest Rate = 10%Stated Interest Rate = 10%Market Interest Rate = 12%Market Interest Rate = 12%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2009 (5 years)Maturity Date = Dec. 31, 2009 (5 years)

Prepare the entry for Jan. 1, 2005 to record the following Prepare the entry for Jan. 1, 2005 to record the following bond issue by Rose Co. bond issue by Rose Co. Par Value = $1,000,000Par Value = $1,000,000Issue Price = 92.6405% of par valueIssue Price = 92.6405% of par valueStated Interest Rate = 10%Stated Interest Rate = 10%Market Interest Rate = 12%Market Interest Rate = 12%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2009 (5 years)Maturity Date = Dec. 31, 2009 (5 years)

Contract rate is: Bond sells:Above market rate At a premiumEqual to market rate At par valueBelow market rate At a discount


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Par Value

Cash Proceeds Discount

1,000,000$ - 926,405$ = 73,595$

Par Value

Cash Proceeds Discount

1,000,000$ - 926,405$ = 73,595$

Amortizing the discount increases Amortizing the discount increases Interest Expense over the outstanding Interest Expense over the outstanding

life of the bond.life of the bond.

Amortizing the discount increases Amortizing the discount increases Interest Expense over the outstanding Interest Expense over the outstanding

life of the bond.life of the bond.

$1,000,000$1,000,000 92.6405%92.6405%$1,000,000$1,000,000 92.6405%92.6405%

Issuing Bonds at a DiscountIssuing Bonds at a Discount

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Jan. 1 Cash 926,405 Discount on bonds payable 73,595

Bonds payable 1,000,000 Sold bonds at a discount on issue date

Contra-LiabilityContra-LiabilityAccountAccount

Contra-LiabilityContra-LiabilityAccountAccount

On Jan. 1, 2005 Rose Co. would record the On Jan. 1, 2005 Rose Co. would record the bond issue as follows. bond issue as follows.



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Partial Balance Sheet as of Jan. 1, 2005

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 73,595 926,405$


Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 73,595 926,405$

Maturity ValueMaturity ValueMaturity ValueMaturity Value

Carrying ValueCarrying ValueCarrying ValueCarrying Value


Using the Using the straight-linestraight-line method, the method, the discount amortization will be $7,360 discount amortization will be $7,360

every six months. every six months.

$73,595 ÷ 10 periods = $7,360* $73,595 ÷ 10 periods = $7,360* *(rounded)*(rounded)

Using the Using the straight-linestraight-line method, the method, the discount amortization will be $7,360 discount amortization will be $7,360

every six months. every six months.

$73,595 ÷ 10 periods = $7,360* $73,595 ÷ 10 periods = $7,360* *(rounded)*(rounded)

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June 30 Bond interest expense 57,360 Discount on bonds payable 7,360 Cash 50,000

Paid semi-annual interest and amortized discount

$73,595 ÷ 10 periods = $7,360 (rounded)

$1,000,000 × 10% × ½ = $50,000

$73,595 ÷ 10 periods = $7,360 (rounded)

$1,000,000 × 10% × ½ = $50,000

Make the following entry every six months to Make the following entry every six months to record the cash interest payment and the record the cash interest payment and the

amortization of the discount.amortization of the discount.

Make the following entry every six months to Make the following entry every six months to record the cash interest payment and the record the cash interest payment and the

amortization of the discount.amortization of the discount.


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Straight-Line Amortization TableInterest Interest Discount Unamortized Carrying

Date Payment Expense Amortization* Discount Value1/1/2005 73,595$ 926,405$

6/30/2005 50,000$ 57,360$ 7,360$ 66,235 933,765 12/31/2005 50,000 57,360 7,360 58,875 941,125 6/30/2006 50,000 57,360 7,360 51,515 948,485

12/31/2006 50,000 57,360 7,360 44,155 955,845 6/30/2007 50,000 57,360 7,360 36,795 963,205

12/31/2007 50,000 57,360 7,360 29,435 970,565 6/30/2008 50,000 57,360 7,360 22,075 977,925

12/31/2008 50,000 57,360 7,360 14,715 985,285 6/30/2009 50,000 57,360 7,360 7,355 992,645

12/31/2009 50,000 57,355 7,355 0 1,000,000 500,000$ 573,595$ 73,595$

* Rounded.

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Prepare the entry for Jan. 1, 2005 to record the Prepare the entry for Jan. 1, 2005 to record the following bond issue by Rose Co. following bond issue by Rose Co. Par Value = $1,000,000Par Value = $1,000,000Issue Price = 108.1145% of par valueIssue Price = 108.1145% of par valueStated Interest Rate = 10%Stated Interest Rate = 10%Market Interest Rate = 8%Market Interest Rate = 8%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2009 (5 years)Maturity Date = Dec. 31, 2009 (5 years)

Prepare the entry for Jan. 1, 2005 to record the Prepare the entry for Jan. 1, 2005 to record the following bond issue by Rose Co. following bond issue by Rose Co. Par Value = $1,000,000Par Value = $1,000,000Issue Price = 108.1145% of par valueIssue Price = 108.1145% of par valueStated Interest Rate = 10%Stated Interest Rate = 10%Market Interest Rate = 8%Market Interest Rate = 8%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2009 (5 years)Maturity Date = Dec. 31, 2009 (5 years)

Issuing Bonds at a PremiumIssuing Bonds at a Premium



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Cash Proceeds Par Value Premium

1,081,145$ - 1,000,000$ = 81,145$

Cash Proceeds Par Value Premium

1,081,145$ - 1,000,000$ = 81,145$

Amortizing the premium Amortizing the premium decreases decreases Interest Interest Expense over the life of the bond.Expense over the life of the bond.

Amortizing the premium Amortizing the premium decreases decreases Interest Interest Expense over the life of the bond.Expense over the life of the bond.

$1,000,000$1,000,000 108.1145%108.1145%

$1,000,000$1,000,000 108.1145%108.1145%


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Jan. 1 Cash 1,081,145 Premium on bonds payable 81,145 Bonds payable 1,000,000

Issued bonds at a premium on issue date

Adjunct-LiabilityAdjunct-LiabilityAccountAccount

Adjunct-LiabilityAdjunct-LiabilityAccountAccount




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Using the straight-line method, the premium Using the straight-line method, the premium amortization will be $8,115 every six months. amortization will be $8,115 every six months.

$81,145 ÷ 10 periods = $8,115 (rounded)$81,145 ÷ 10 periods = $8,115 (rounded)

Using the straight-line method, the premium Using the straight-line method, the premium amortization will be $8,115 every six months. amortization will be $8,115 every six months.

$81,145 ÷ 10 periods = $8,115 (rounded)$81,145 ÷ 10 periods = $8,115 (rounded)


Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 81,145 1,081,145$


Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 81,145 1,081,145$


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June 30 Bond interest expense 41,885 Premium on bonds payable 8,115

Cash 50,000 Paid semi-annual interest and amortized premium

$81,145 ÷ 10 periods = $8,115 (rounded)

$1,000,000 × 10% × ½ = $50,000

$81,145 ÷ 10 periods = $8,115 (rounded)

$1,000,000 × 10% × ½ = $50,000

This entry is made every six months to This entry is made every six months to record the cash interest payment and the record the cash interest payment and the

amortization of the premium.amortization of the premium.

This entry is made every six months to This entry is made every six months to record the cash interest payment and the record the cash interest payment and the

amortization of the premium.amortization of the premium.


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Straight-Line Amortization TableInterest Interest Premium Unamortized Carrying

Date Payment Expense Amortization* Premium Value1/1/2005 81,145$ 1,081,145$

6/30/2005 50,000$ 41,885$ 8,115$ 73,030 1,073,030 12/31/2005 50,000 41,885 8,115 64,915 1,064,915 6/30/2006 50,000 41,885 8,115 56,800 1,056,800

12/31/2006 50,000 41,885 8,115 48,685 1,048,685 6/30/2007 50,000 41,885 8,115 40,570 1,040,570

12/31/2007 50,000 41,885 8,115 32,455 1,032,455 6/30/2008 50,000 41,885 8,115 24,340 1,024,340

12/31/2008 50,000 41,885 8,115 16,225 1,016,225 6/30/2009 50,000 41,885 8,115 8,110 1,008,110

12/31/2009 50,000 41,890 8,110 0 1,000,000 500,000$ 418,855$ 81,145$

* Rounded.

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Accrued interestAccrued interest

Investor pays bond purchase Investor pays bond purchase price price ++ accrued interest. accrued interest.

Jan. 1, 2005Jan. 1, 2005 Bond Date Bond Date

Apr. 1, 2005Apr. 1, 2005Bond Issue Bond Issue

DateDate

June 30, 2005June 30, 2005First Interest First Interest

PaymentPayment

Issuing Bonds Between Interest DatesIssuing Bonds Between Interest Dates

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Accrued interestAccrued interest

Jan. 1, 2005Jan. 1, 2005 Bond Date Bond Date

Apr. 1, 2005Apr. 1, 2005Bond Issue Bond Issue

DateDate

June 30, 2005June 30, 2005First Interest First Interest

PaymentPayment


Investor Investor receives 6 receives 6 months’ months’ interest.interest.

Earned interestEarned interest

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Prepare the entry to record the following bond issue Prepare the entry to record the following bond issue by King Co. on Apr. 1, 2005. by King Co. on Apr. 1, 2005. Par Value = $1,000,000Par Value = $1,000,000Stated Interest Rate = 10%Stated Interest Rate = 10%Market Interest Rate = 10%Market Interest Rate = 10%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2009 (5 years)Maturity Date = Dec. 31, 2009 (5 years)

Prepare the entry to record the following bond issue Prepare the entry to record the following bond issue by King Co. on Apr. 1, 2005. by King Co. on Apr. 1, 2005. Par Value = $1,000,000Par Value = $1,000,000Stated Interest Rate = 10%Stated Interest Rate = 10%Market Interest Rate = 10%Market Interest Rate = 10%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2005Bond Date = Jan. 1, 2005Maturity Date = Dec. 31, 2009 (5 years)Maturity Date = Dec. 31, 2009 (5 years)


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At the date of issue the following entry is made:At the date of issue the following entry is made:


The first interest payment on June 30, 2005 is:The first interest payment on June 30, 2005 is:

Apr. 1 Cash 1,025,000 Interest payable 25,000 Bonds payable 1,000,000

Issued bonds at par plus accrued interest

June 30 Interest payable 25,000 Bond interest expense 25,000

Cash 50,000 Paid semi-annula interest

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Jan. 1 Apr. 1 Dec. 31

End of accounting

periodOct. 1

Interest Payment Dates

At year-end, an At year-end, an adjusting entryadjusting entry is necessary to is necessary to recognize bond interest expense accrued since recognize bond interest expense accrued since

the most recent interest payment.the most recent interest payment.

At year-end, an At year-end, an adjusting entryadjusting entry is necessary to is necessary to recognize bond interest expense accrued since recognize bond interest expense accrued since

the most recent interest payment.the most recent interest payment.

3 months’ accrued interest

Accruing Bond Interest ExpenseAccruing Bond Interest Expense

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At Maturity

Before MaturityCarrying Value > Retirement Price = GainCarrying Value < Retirement Price = Loss

Bond RetirementBond Retirement

Dec. 31 Bonds payable 1,000,000 Cash 1,000,000

Retirement of bonds at maturity

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Are you Are you ready to ready to

discuss long-discuss long-term notes term notes payable?payable?

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Note Maturity Date

Note PayableNote PayableNote PayableNote Payable

Cash

Company Lender

Note Date

When is the repayment of the principal When is the repayment of the principal and interest going to be made?and interest going to be made?

Long-Term Notes PayableLong-Term Notes Payable

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Note Maturity Date

Company Lender

Note Date


Single Payment of Single Payment of Principal plus Principal plus

InterestInterest

Single Payment of Single Payment of Principal plus InterestPrincipal plus Interest

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Note Maturity Date

Company Lender

Note Date


Regular Payments of Principal plus InterestRegular Payments of Principal plus Interest

Payments can either be equal principal payments

or equal payments.

Regular Payments of Principal plus Interest

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Installment Notes with Equal Principal PaymentsInstallment Notes with Equal Principal Payments

$-

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Interest

Principal

The principal payments are $10,000 each year.The principal payments are $10,000 each year.Interest expense decreases each year.Interest expense decreases each year.

The principal payments are $10,000 each year.The principal payments are $10,000 each year.Interest expense decreases each year.Interest expense decreases each year.

Annual Annual payments payments decrease.decrease.

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Installment Notes with Equal PaymentsInstallment Notes with Equal Payments

$-

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Interest

Principal

The principal payments increase each year. The principal payments increase each year. Interest expense decreases each year.Interest expense decreases each year.

The principal payments increase each year. The principal payments increase each year. Interest expense decreases each year.Interest expense decreases each year.

Annual Annual payments are payments are

constant.constant.

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A legal agreement that helps protect the A legal agreement that helps protect the lender if the borrower fails to make the lender if the borrower fails to make the required payments.required payments.

Gives the lender the right to be paid out of Gives the lender the right to be paid out of the cash proceeds from the sale of the the cash proceeds from the sale of the borrower’s assets specifically identified in borrower’s assets specifically identified in the mortgage contract. the mortgage contract.

A legal agreement that helps protect the A legal agreement that helps protect the lender if the borrower fails to make the lender if the borrower fails to make the required payments.required payments.

Gives the lender the right to be paid out of Gives the lender the right to be paid out of the cash proceeds from the sale of the the cash proceeds from the sale of the borrower’s assets specifically identified in borrower’s assets specifically identified in the mortgage contract. the mortgage contract.

Mortgage Notes and BondsMortgage Notes and Bonds

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Pledged Assets to Secured

Liabilities

Book Value of Pledged Assets

Book Value of Secured Liabilities=

This ratio helps creditors determine whether the This ratio helps creditors determine whether the pledged assets of a debtor provide adequate pledged assets of a debtor provide adequate

security for secured debt obligations.security for secured debt obligations.

This ratio helps creditors determine whether the This ratio helps creditors determine whether the pledged assets of a debtor provide adequate pledged assets of a debtor provide adequate

security for secured debt obligations.security for secured debt obligations.

Pledged Assets to Secured LiabilitiesPledged Assets to Secured Liabilities

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Homework for Chapter 14Homework for Chapter 14

Ex 14-8, 14-15 Problem 14-2A Due on July 12, 2006 (Wed)

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End of Chapter 14End of Chapter 14

mcgraw-hill/irwin 14-1 © the mcgraw-hill companies, inc., 2005 long-term liabilities chapter 14

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