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Chapter 14: Long Term Liabilities

Chapter 14: Long Term Liabilities. Reminder: Scholarship applications are due Feb. 1. Part 1: Bonds Payable. Long-Term Debt: General. Long term debt consists of probable future sacrifices. It has various covenants or restrictions for the protection of both lenders and borrowers.

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Chapter 14: Long Term Liabilities

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  1. Chapter 14: Long Term Liabilities Reminder: Scholarship applications are due Feb. 1

  2. Part 1: Bonds Payable

  3. Long-Term Debt: General • Long term debt consists of probable future sacrifices. • It has various covenants or restrictions for the protection of both lenders and borrowers. • The indenture or agreement incorporates the terms of the issue and restrictions. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  4. Issuing Bonds • Bonds are the most common type of long term debt. • They are usually issued in denominations of $1,000. • A bond indenture is a promise (by the lender to the borrower) to pay: • a sum of money at the designated date, and • periodic interest at a stipulated rate on the face value • A bond issue may be sold: • either through an investment banker, or • by private placement Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  5. Select Types of Bonds • Secured and unsecured bonds: bonds secured by collateral (real estate, stocks) • Serial bonds: mature in installments • Callable bonds: give issuer to call and retire debt prior to maturity • Convertible bonds: can be converted into other corporate securities for a specified time after issue • Bearer bonds: are freely transferable by current owner. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  6. lend cash 1. Bond Certificate 2. Periodic interest 3. Redemption of Face Value Bond Issues: Parties to the Contract Issuer of Bonds Bondholders Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  7. Valuation of Bonds:Determining Bond Prices • The price of a bond issue is determined by: • the present value of the annuity of interest payments (at the contractual rate of interest), and • the present value of the redemption (face) value, • both discounted at the market rate of interest at issue date. • Interest payments by borrower are calculated as: • Face value of bond issue * contractual interest rate (as specified in the bond indenture) Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  8. Valuation of Bonds: Determining Bond Prices - Example • Given: (1/1/05) • Face value of bond issue: $100,000 • Term of issue: 5 years • Contractual interest rate: 9% per year, payable annually on 12/31 • Market rate of interest: 11% • Determine the issue price of the bonds. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  9. Year 1 Year 2 Year 3 Year 4 Year 5 interest $9,000 $9,000 $9,000 $9,000 $9,000 Redemption at maturity ==> $100,000 face value Valuation of Bonds: Determining Bond Prices - Cash Flows Interest = $100,000 * 9% per year contractual rate Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  10. Year 1 Year 2 Year 3 Year 4 Year 5 interest $9,000 $9,000 $9,000 $9,000 $9,000 $ 33,262 Discount at market rate, 11% $9,000 * 3.69590 plus Discount at market rate, 11% $100,000 * 0.59345 $100,000 $ 59,345 Valuation of Bonds: Determining Bond Prices - Present Value of Cash Flows =$92,607 is the issue price Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  11. The entry to record the bond issuance on 1/1/05: • Dr. Cash 92,607 • Dr. Discount on B/P 7393 • Cr. B/P 100,000 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  12. To record the periodic interest(using straight-line amortization method for the discount) • 12/31/05 - 09 • Dr. Interest Expense 10,479 • Cr. Discount on B/P 1,479 • Cr. Cash 9,000 • Amortization: 7393/5 • Interest expense is higher than the interest actually paid each period because the discount is in essence a lump sum payment by the issuer to compensate the buyer of the bonds for the lower periodic interest payment Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  13. To record the interest expense using Effective Interest Amortization • Amortization Schedule for Discount Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  14. 12/31/05 • Dr. Interest Expense 10,187 • Cr. Discount on B/P 1,187 • Cr. Cash 9,000 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  15. A Note on Amortization Methods • The straight line method allocates the same amount of discount (or premium) to each interest period. • The effective interest method allocates the discount or premium in increasing amounts over the bond term (see following examples) • However, the total discount or premium amortized is the same under both methods. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  16. Bonds Payable: Face Value, Discount, and Carrying Value - Concept 1. Face value remains the same throughout the bond term. 2. Unamortized discount gradually decreases over the bond term. 3. Carrying value gradually increases and is equal to face value at redemption. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  17. Bond Issue Pricing: Concept Relationship Relationship Rationale between between contractual rate Issue Price and market rate and Face Value CR = Mkt Rate Issue Price = F.V Market rate is the same as Bond rate CR < Mkt Rate Issue Price < F.V. Issuer offers a discount to b/holder to compensate for lower bond interest CR > Mkt Rate Issue Price > F.V. Issuer gets a premium for higher bond interest Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  18. Bonds Issued at a Premium on Interest Date: Straight Line Amortization • Given: (Fiscal year is calendar year) • Face value of bonds issued: $ 100,000 • Issue Price: (issue at 108.53) $ 108,530 • Market Rate: 6% • Contractual Rate: 8% • Date of issue: January 1, 2000 • Interest dates: July 1 and Jan 1 • Term of issue: 5 years • Give the journal entries for issue and interest payment. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  19. Bonds Issued at a Premium on Interest Date: Straight Line Amortization • January 1, 2000 (Issue): • Cash $108,530 • Bonds Payable $100,000 • Premium on Bonds Payable $ 8,530 • July 1, 2000 (Interest Payment): • Interest Expense $ 3,147 • Premium on Bonds Payable $ 853 • Cash $ 4,000 • Note: Premium amortized = $ 8,530 / 10 payments = $ 853 Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  20. Bond Issued between Interest Dates: Concept • Bonds may be issued between interest dates. • Interest, for the periodbetween the issue date and the last interest date, is collected with the issue price of the bonds. • At the specified interest date, interest is paid for the entire interest period (semi annual or annual) • Premium or discount is also amortized from the date of sale of bonds to the end of the interest period. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  21. Bonds Issued at a Premium between Interest Dates: Straight Line Amortization • Given: (Fiscal year is calendar year) • Face value of bonds issued: $ 100,000 • Issue Price: (issue at 108.53) $ 108,530 • Market Rate: 6% • Contractual Rate: 8% • Date of issue: March 1, 2000 • Interest dates: July 1 and Jan 1 • Term of issue: 5 years • Give the journal entries for issue and interest payment. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  22. Bonds Issued at a Premium between Interest Dates: Straight Line Amortization • March 1, 2000 (Issue): • Cash $109,863 • Bonds Payable $100,000 • Premium on Bonds Payable $ 8,530 • Bond Interest Expense (2 months) $ 1,333 • July 1, 2000 (Interest Payment): • BondInterest Expense $ 3,431 • Premium on Bonds Payable $ 569 • Cash $ 4,000 • Note: Premium amortized = ($853 / 6) * 4 months Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  23. Classification of Discount on Bonds Payable • Discount on bonds payable is a contra liability account and is shown as: • Bonds Payable (face value) : $ XXX • less: Unamortized Discount : ($ XX) • Bonds Payable (carrying value): $ XXX Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  24. Classification of Premium on Bonds Payable • Premium on bonds payable is an adjunct account and is shown as: • Bonds Payable (face value) : $ XXX • Add: Unamortized Premium : $ XX • Bonds Payable (carrying value): $ XXX Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  25. Accounting for the Costs of Issuing Bonds • Costs of issue must be amortized over the life of the bond issue. • Even though both straight line and effective interest methods are acceptable, the straight line method is used in most cases. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  26. Extinguishment of Debt • When debt is extinguished (paid), • any premium or discount on bond issue must be amortized up to the date of extinguishment, and • any bond issue costs must be amortized up to date of extinguishment. • Any gain or loss from extinguishment of debt is treated as an extraordinary item. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  27. Extinguishment of Debt: Example • Given: • Existing debt: $800,000 • Called and canceled at $808,000 • Unamortized discount: $ 14,400 • Unamortized bond issue costs: $ 9,600 • Note: Both discount and bond issue costs have been amortized up to the date of cancellation of debt. • Give the journal entry for the extinguishment. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

  28. Extinguishment of Debt: Example • Bonds Payable $800,000 • Loss on Extinguishment $ 32,000 • Discount on Bonds $ 14,400 • Unamortized Bond Issue Costs $ 9,600 • Cash $ 808,000 • Note: The loss is a balancing figure and an extraordinary item. Intermediate Accounting, 10th Edition, Chapter 14 (Kieso et al.)

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