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Long-Term Liabilities

Long-Term Liabilities. Chapter 15. Bonds: 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. Types of Bonds. Term bonds. Secured or

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Long-Term Liabilities

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  1. Long-Term Liabilities Chapter 15

  2. Bonds: 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

  3. Types of Bonds Term bonds Secured or mortgage bonds Serial bonds Debenture bonds

  4. Bond 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.

  5. Present 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.

  6. Issuing Bonds Payableto Borrow Money • On January 1, Granite Corp. issued $1,000,000 of 10%, 10-year bonds. January 1 Cash 1,000,000 Bonds Payable 1,000,000 To issue 10%, 10-year bonds

  7. Issuing Bonds Payableto Borrow Money • What is the entry for the interest payment of July 1? • $1,000,000 × 10% × 1/2 = $50,000 July 1 Interest Expense 50,000 Cash 50,000 To record semiannual interest

  8. Issuing Bonds and Notes PayableBetween Interest Dates • On March 31, Granite Corp. sells $1,0000,000 of 10%, 10-year bonds dated January 1. March 31 Cash 1,025,000 Bonds Payable 1,000,000 Interest Payable 25,000 To issue 10%, 10-year bonds at par three months after original issue date

  9. Issuing Bonds and Notes PayableBetween Interest Dates • What is the July 1 interest expense? • $1,000,000 × 10% × 1/4 = $25,000 June 30 Interest Expense 25,000 Interest Payable 25,000 Cash 50,000 To pay semiannual interest

  10. Issuing Bonds Payableat a Discount A 10-year, $1,000,000 bond issue is sold by Granite Corp. at 99¼ on January 1. The contract rate of interest is 10% (20 periods). Cash 992,500 Discount on Bonds Payable 7,500 Bonds Payable 1,000,000 To issue 10%, 10-year bonds at a discount

  11. Account for basic bonds payable transactions by the straight-line amortization method. Objective 1

  12. Straight-Line Amortizationof 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

  13. Straight-Line Amortizationof Bond Discount July 1 Interest Expense 50,375 Cash 50,000 Discount on Bonds Payable 375 Paid semiannual interest and amortized discount on bonds payable

  14. Issuing Bonds Payableat a Premium Granite Corp. sold a 10%, 10-year (20 periods), $1,000,000 bond issue at a price of 101 on Jan. 1. Cash 1,010,000 Bonds Payable 1,000,000 Premium on Bonds Payable 10,000 Issued bonds payable at a premium

  15. Issuing Bonds Payableat a Premium Granite Balance Sheet (immediately after issuance of the bonds) Long-term liabilities: Bonds payable, 10%, due 20xx $1,000,000 Premium of bonds payable 10,000 $1,010,000

  16. Straight-Line Amortizationof Bond Premium July 1 Interest Expense 40,500 Premium on Bonds Payable 500 Cash 50,000 Paid semiannual interest and amortized premium on bonds payable

  17. Reporting Bonds Payable Granite Balance Sheet (December 31) Long-term liabilities: Bonds payable, 10%, due 20xx $1,000,000 Premium on bonds payable 9,000 $1,009,000

  18. Adjusting Entries for Interest Expense • 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?

  19. Adjusting Entries for Interest Expense • 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?

  20. Adjusting Entries for Interest Expense December 31, 2002 Interest Expense 3,075 Interest Payable 3,000 Discount on Bonds Payable 75 Accrued three months’ interest and amortized discount on bonds payable What is the entry on March 31, 2003?

  21. Adjusting Entries for Interest Expense March 31, 2003 Interest Expense 3,075 Interest Payable 3,000 Cash 6,000 Discount on Bonds Payable 75 Paid semiannual interest, part of which was accrued, and amortized three months’ discount on bonds payable

  22. Measure interest expense by the effective-interest method. Objective 2

  23. Effective-Interest Methodof 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.

  24. Effective-Interest Method:Bond 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.

  25. Effective-Interest Method:Bond Discount Cash 96,149 Discount on Bonds Payable 3,851 Bonds Payable 100,000 To issue 10%, 10-year bonds at a discount

  26. Effective-Interest Method:Bond Discount • 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

  27. Effective-Interest Method:Bond Discount End of Carrying Interest Cash Period Value Expense Paid Amortization Issue 96,149 Date 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

  28. Effective-Interest Method:Bond 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

  29. Effective-Interest Method:Bond Discount End of Carrying Interest Cash Period Value Expense Paid Amortization Issue 104,100 Date 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

  30. Account for retirement of bonds payable. Objective 3

  31. Retirement of Bonds Payable • 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.

  32. Retirement of Bonds Payable Example $500,000 of 12% bonds with an unamortized premium of $20,000 are purchased for $498,000 and retired. Bonds Payable 500,000 Premium of Bonds Payable 20,000 Cash 498,000 Extraordinary Gain on Retirement of Bonds 22,000 Retired bonds payable

  33. Account for conversion of bonds payable. Objective 4

  34. Convertible Bonds and Notes • 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.

  35. Current Portion of Long-Term 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.

  36. Mortgage Notes Payable • A mortgage is a security agreement that pledges certain assets as collateral for a note. • If it is not paid in a timely fashion, the borrower will have to transfer title to the lender. • Mortgage notes are usually paid in monthly installments.

  37. Show the advantages and disadvantages of borrowing. Objective 5

  38. Issuing Bonds versus Stock • 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. • 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.

  39. Advantage of Issuing Bondsversus 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%.

  40. Advantage of Issuing Bondsversus Stock Example • 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?

  41. Advantage of Issuing Bondsversus Stock Example Borrow $500,000 Expected net income on the new project $200,000 Interest expense – 50,000 Project income before taxes $150,000 Income tax expense – 60,000 Project net income $ 90,000 Net income before expansion $300,000 Total income $390,000

  42. Advantage of Issuing Bondsversus Stock Example Issue 50,000 shares of common stock at $10 per share Expected net income on the new project $200,000 Income tax expense – 80,000 Project net income $120,000 Net income before expansion $300,000 Total income $420,000

  43. Advantage of Issuing Bondsversus Stock Example 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

  44. Account for lease liabilities and pension liabilities. Objective 6

  45. Leases • A lease is a rental agreement that allows the lessee use of an asset without a large cash down payment. • For accounting purposes there are two types of leases: • Operating lease • Capital lease

  46. Capital Lease • Any one of the following qualifies an agreement as a capital lease: • It transfers title at the end of the term. • It contains a bargain purchase option. • The term covers 75% or more of the estimated useful life of the asset. • The present value of the lease exceeds 90% of the market value of the asset.

  47. Pension and PostretirementBenefits Liabilities • As the employees work, the company accrues the expense and the liability of providing benefits during retirement. • Debit Pension Expense and credit Cash. • At the end of each period, the company compares the fair market value of the pension plan assets with the accumulated benefit obligation.

  48. Pension and PostretirementBenefits Liabilities • The accumulated benefit obligation is the amount of promised future pension payments to retirees. • If the plan is underfunded, the excess liability must be recorded as a long-term pension liability.

  49. Appendix • What is the present value of $4,500 interest to be received for 10 periods at 5%? • The present value annuity table indicates that 7.722 is the factor for 10 periods at 5%. • The present value of the future interest is $4,500 × 7.722 = $34,749.

  50. Appendix • What is the present value of a lump sum of $100,000, 10 periods from now at 5%? • The present value table indicates that .614 is the factor to be used in determining the value of $100,000 to be received 10 periods from now at 5%. • $100,000 × .614 = $61,400

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