John Wiley & Sons, Inc. © 2005

Chapter 16Chapter 16

LONG-TERM LIABILITIES

Prepared by Naomi KarolinskiPrepared by Naomi KarolinskiMonroe Community CollegeMonroe Community College

andandMarianne BradfordMarianne Bradford

Bryant CollegeBryant College

Accounting Principles, 7Accounting Principles, 7thth Edition EditionWeygandt Weygandt •• Kieso Kieso •• Kimmel Kimmel

CHAPTER 16LONG-TERM LIABILITIES

After studying this chapter, you should be able to:1 Explain why bonds are issued.2 Prepare the entries for the issuance of bonds

and interest expense.3 Describe the entries when bonds are

redeemed or converted.4 Describe the accounting for long-term notes

payable.5 Contrast the accounting for operating and

capital leases.6 Identify the methods for the presentation

and analysis of long-term liabilities.

Long-Term Liabilities

• Obligations that are expected to be paid after one year

• Include bonds, long-term notes, and lease obligations

Bond BasicsSTUDY OBJECTIVE 1

• Bonds – interest-bearing notes payable– issued by corporations, universities, and

governmental agencies – like common stock, can be sold in small

denominations (usually a thousand dollars)– attract many investors

• To obtain large amounts of long-term capital, corporate management usually must decide whether to issue bonds or to use equity financing (common stock).

Why Issue Bonds?

Long-term financing, bonds, offer thefollowing advantages over commonstock:1)Stockholder control not affected2)Tax savings 3)Earnings per share may be

higher

Disadvantages of Bonds

1)Interest must be paid on a periodic basis

2)Principal (face value) must be repaid at maturity

1) Secured bonds Specific assets of the issuer pledged as collateral for the bonds( a mortgage bond is secured by real estate)

2) Unsecured bonds Issued against the general credit of the borrower; they are also called debenture bonds.

Types of BondsSecured and Unsecured

3) Term bonds• bonds that mature at a single

specified future date

4) Serial bonds• bonds that mature in installments

Types of Bonds: Term and Serial Bonds

2005 2006 2007 2008

2005 2006 2007 2008Registered

Registered

Registered

Types of Bonds:Registered and Bearer

5)Registered bonds

• issued in the name of the owner and have interest payments made by check to bondholders of record

6)Bearer or coupon bonds

• not registered; thus bondholders must send in coupons to receive interest payments

Pay to: Bearer

RegisteredPay to: Joe Smith

Types of BondsConvertible and Callable

• Convertible– convert the bonds

into common stock at holder’s option

• Callable– subject to call and

retirement at a stated dollar amount prior to maturity at the option of the issuer

Authorizing a Bond Issue• State laws grant corporations the power to

issue bonds– approval by both the Board of Directors and

stockholders is usually required• Board of Directors stipulate the number of

bonds to be authorized, total face value, and contractual interest rate

Issuing Procedures

• Face value – amount of principal the issuer must pay at the

maturity date• Contractual interest rate, or stated rate

– rate used to determine the amount of cash interest the borrower pays and the investor receives

• Bond indenture – terms of the bond issue are set forth in a formal

legal document • Bond certificates

– Printed document providing information such as name of issuer and maturity date

Bond Certificate

Bond Trading

• Corporate bonds– traded on national securities exchanges– bondholders have the opportunity to convert their holdings

into cash by selling the bonds at the current market price• Bond prices are quoted as a percentage of the face

value of the bond (usually $1,000). • Transactions between a bondholder and other

investors are not journalized by the issuing corporation.

• A corporation only makes journal entries when it issues or buys back bonds, and when bondholders convert bonds into common stock.

Determining the Market Value of Bonds

The market value (present value)of a bond is determined by:1) the dollar amounts to be received2) the length of time until the amounts are received3) the market rate of interest, which is the rate

investors demand for loaning funds. • The process of finding the present value is

referred to as discounting the future amounts.

Accounting for Bond IssuesIssuing Bonds at Face Value

STUDY OBJECTIVE 2

1,000,000 1,000,000

Bonds may be issued at face value, below face value (at a discount), or above face value (at a premium). They also are sometimes issued between interest dates. Assume that Devor Corporation issues 1,000, 10-year, 9% $1,000 bonds dated January 1, 2005, at 100 (100% of face value). The entry to record the sale is:

Bonds payable are reported in the long-term liability section of the balance sheet because the maturity date is more than one year away.

Accounting for Bond IssuesIssuing Bonds at Face Value

45,000 45,000

Assuming that interest is payable semiannually on January 1 and July 1 on the bonds, interest of $45,000 ($1,000,000 x 9% x 6/12)must be paid on July 1, 2005. The entry for the payment is:

Accounting for Bond IssuesIssuing Bonds at Face Value

45,000 45,000

At December 31, an adjusting entry is required to recognizethe $45,000 of interest expense incurred since July 1.The entry is:

Bond interest payable is classified as a current liability, because it is scheduled for payment within the next year. When interest is paid on January 1, 2006, Bond Interest Payable is debited, and Cash is credited for $45,000 in order to eliminate the liability.

Interest Rates and Bond Prices

BONDCONTRACTUAL

INTERESTRATE 10%

Issuedwhen:

8%

10%

12%

Premium

Face Value

Discount

Market Rates Bonds Sell at:

Accounting for Bond IssuesDiscount or Premium on Bonds

• Bonds may be issued below or above face value.

• Market (effective) rate of interest is higher than the contractual (stated) rate– the bonds will sell at less than face value, or at a

discount• Market rate of interest is less than the

contractual rate – the bonds will sell above face value, or at a premium

Issuing Bonds at a Discount

Assume that on January 1, 2005, Candlestick, Inc. sells$100,000, 5-year, 10% bonds for $92,639 (92.639% of face value) with interest payable on July 1 and January 1. The entry to record the issuance is:

The $92,639 represents the carrying (or book) value of the bonds. On the date of issue this amount equals the market price of the bonds.

Statement Presentation of Discount on Bonds Payable

Although Discount on Bonds Payable has a debit balance, it is NOT an asset. Rather, it is a contra account, whichis deducted from bonds payable on the balance sheet, as illustrated below:

Total Cost of Borrowing - Bonds Issued at Discount

• The difference between the issuance price and face value of the bonds-the discount-is an additional cost of borrowing that should be recorded as bond interest expense over the life of the bonds.

• The total cost of borrowing, $92,639 for Candlestick, Inc., is $57,361, as computed as follows:

Semiannual Interest Payments($100,000*10%*.5= $5,000; $5,000*10) $50,000Add: Bond Discount ($100,000-$92,639) $7,361 Total Cost of Borrowing $57,361

Bonds Issued at a Discount

Alternative Computation of Total Cost of Borrowing - Bonds Issued at a Discount

Alternatively, the total cost of borrowing can be computed as follows:

Total cost of borrowing $57,361

Principal at maturity $100,000Semiannual interest payments ($5,000*10) $50,000Cash to be paid to bondholders $150,000Cash received from bondholders $92,639

Bonds Issued at a Discount

Issuing Bonds at a Premium

We now assume the Candlestick, Inc. bonds described in the previous slides are sold for $108,111 (108.111% of face value) rather than for $ 92,639.

108,111 100,000 8,111

Statement Presentation of Bond Premium

Premium on bonds payable is added to bonds payable on the balance sheet, as shown below:

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid. The premium is considered to be a reduction in the cost of borrowing that should be credited to Bond Interest Expense over the life of the bonds.

Total Cost of Borrowing - Bonds Issued at a Premium

Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) $50,000Less: Bond Premium ($108,111-$100,000) $8,111 Total Cost of Borrowing $41,889

Bonds Issued at a Premium

Alternative Computation of Total Cost of Borrowing - Bonds Issued at

a Premium

Alternatively, the total cost of borrowing can be determined as follows:

Total cost of borrowing $41,889

Principal at maturity $100,000Semiannual interest payments ($5,000*10) $50,000Cash to be paid to bondholders $150,000Cash received from bondholders $108,111

Bonds Issued at a Premium

Redeeming Bonds at MaturitySTUDY OBJECTIVE 3

1,000,000 1,000,000

Regardless of the issue price of bonds, the book valueof the bonds at maturity will equal their face value.Assuming that the interest for the last interest periodis paid and recorded separately, the entry to record the redemption of the Candlestick bonds at maturity is:

Bond Retirements• Company decides to reduce interest

cost and remove debt from its balance sheet.

1)Eliminate the carrying value of the bonds at the redemption date.

2)Record the cash paid.3)Recognize the gain or loss on

redemption.

Redeeming Bonds Before Maturity

Assume that at the end of the eighth period, Candlestick, Inc.retires its bonds at 103 after paying the semiannual interest. The carrying value of the bonds at the redemption date is$101,623. The entry to record the redemption at the endof the eighth interest period (January 1, 2009) is:

100,000 1,6231,377 103,000

The term used for bonds that are unsecured is:a. callable bonds.b. indenture bonds.c. debenture bonds.d. bearer bonds.

Chapter 16

The term used for bonds that are unsecured is:a. callable bonds.b. indenture bonds.c. debenture bonds.d. bearer bonds.

Chapter 16