1 Financial Accounting Chapter Nine LongTerm Liabilities Copyright

Learning Objectives 1. Account for bonds 4. Describe other longpayable and interest term liabilities expense with straight- 5. Analyze the impact line amortization of leverage on the 2. Account for bonds financial statements payable and interest 6. Report long-term expense with liabilities on the effective interest financial statements amortization 3. Account for other features of bonds payable Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -2

1 Learning Objective One Account for bonds payable and interest expense with straight-line amortization

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Bonds: An Introduction • Debts of an issuing company • Bond certificate states: • Issuing company’s name • Principal (face value, maturity value, par value) • Maturity date • Annual interest rate • Interest payment dates Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -4

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Bonds: An Introduction • Types of bonds: Term: all mature at the same time • Serial: mature in installments over time • Secured: give the bondholder the right to assets of the issuer if the company defaults • Unsecured (debentures): backed only by the good faith of the borrower • Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -5

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Bonds: An Introduction • Bond Prices • • Quoted as a percentage of their maturity value Bond Premium and Bond Discount • Premium issued above face value (credit balance) • Discount issued below face value (debit balance) Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -6

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Bonds: An Introduction • Time value of money • • Affects the pricing of bonds – see Appendix F Bond interest rates determine bond prices • Always sold at market price (bond’s present value) • Stated interest rate (coupon rate) • Market interest rate (effective interest rate) Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -7

1 Exhibit 9 -1 | How Stated Interest Rates and Market Interest Rates Interact

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at Par. Suppose Southwest Airlines has $100, 000 of 9% bonds payable that mature in five years. Southwest issued these bonds at par on January 1, 2018. Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -9

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at Par. Interest payments occur each January 1 and July 1. Southwest’s entry to record the first semiannual interest payment is as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -10

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at Par. At year-end, Southwest accrues interest expense and interest payable for six months (July through December), as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -11

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at Par. At maturity, January 1, 2023, Southwest pays off the bonds as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -12

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at a Discount. Southwest Airlines issued $100, 000 of 9%, five-year bonds when the market interest rate is 10%. The market price of the bonds drops, and Southwest receives $96, 150 at issuance. Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -13

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Southwest’s balance sheet:

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Each semiannual cash interest payment is set by the bond contract and remains constant over the life of the bond: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -15

Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at a Discount 1 • Interest expense increases each period • Discount amortized over term of the bonds • Straight-line amortization divides the bond discount into equal amounts over bond’s term Southwest’s bond amortization is calculated as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -16

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at a Discount. Southwest’s entry to record interest expense on July 1, 2018 using the straight-line amortization method is as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -17

1 Account for Bonds Payable and Interest Expense with Straight-Line Amortization Issuing Bonds Payable at a Premium. Suppose the $100, 000 face amount of Southwest’s bonds is issued at a price of 103. 85 ($103, 850). Using the straight-line method, the interest expense and premium amortization is recorded as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -18

2 Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -19

2 Learning Objective Two Account for bonds payable and interest expense with effective interest

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization The Effective-Interest Method • Most theoretically correct method • Recognizes time value of money on interest expense • Interest expense is different each period • Steps • Determine exact price at issuance • Build amortization table Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -21

2 Exhibit 9 -2 | Amortization of Bond Discount Copyright © 2019 Pearson Education,

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Interest Expense on Bonds Issued at a Discount Column B: Interest payment is fixed by contract Column C: Interest expense increases as the discount bond approaches maturity Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -24

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Interest Expense on Bonds Issued at a Discount Interest Expense = Market interest rate of 5% x Preceding bond carrying amount 4, 807 = . 05 x 96, 149 Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -25

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Interest Expense on Bonds Issued at a Discount Column D: Interest Payment – Interest Expense = Discount Amortization Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -26

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Interest Expense on Bonds Issued at a Discount Column E: Discount balance decreases when amortized Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -27

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Interest Expense on Bonds Issued at a Discount Column F: Bond carrying amount increases from issuance to maturity by the amount of the discount amortization each period Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -28

2 Exhibit 9 -3 | Interest Expense on Bonds Payable Issued at a Discount

2 Exhibit 9 -4 | Amortizing Discount on Bonds Payable Copyright © 2019 Pearson

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Issuing Bonds Payable at a Discount. Southwest’s journal entry to record interest expense and the interest payment for the first six months follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -31

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Issuing Bonds Payable at a Discount. At December 31, 2018, Southwest accrues interest and amortizes the bond discount for July through December as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -32

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Issuing Bonds Payable at a Premium. On January 1, 2018, Southwest issued $100, 000 of 9%, five-year bonds when the market interest rate is 8%. The issue price is $104, 100. The issuance of the bonds is recorded as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -33

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Southwest’s balance

2 Exhibit 9 -5 | Amortization of Bond Premium Copyright © 2019 Pearson Education,

2 Exhibit 9 -5 | Amortization of Bond Premium Column B: Interest payment is fixed by contract Column C: Interest expense decreases as the premium bond approaches maturity Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -37

2 Exhibit 9 -5 | Amortization of Bond Premium Interest Expense = Market interest rate of 4% x Preceding bond carrying amount 4, 164 = . 04 x 104, 100 Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -38

2 Exhibit 9 -5 | Amortization of Bond Premium Column D: Interest payment –

2 Exhibit 9 -5 | Amortization of Bond Premium Column E: Premium balance decreases

2 Exhibit 9 -5 | Amortization of Bond Premium Column F: Bond carrying amount decreases from issuance to maturity as the premium is amortized Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -41

2 Account for Bonds Payable and Interest Expense with Effective Interest Amortization Issuing Bonds Payable at a Premium. Southwest’s journal entry to record interest expense and the interest payment for the first six months follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -42

2 Exhibit 9 -6 | Interest Expense on Bonds Payable Issued at a Premium

2 Exhibit 9 -7 | Amortizing Premium on Bonds Payable Copyright © 2019 Pearson

3 Learning Objective Three Account for other features of bonds payable Copyright © 2019

3 Account for Other Features of Bonds Payable Partial-Period Interest Amounts. Google, Inc. issues $100, 000 of 8% bonds payable at 96 on August 31, 2018. The market interest rate was 9%, and these bonds pay semiannual interest. The first few lines of Google’s amortization table are as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -46

3 Account for Other Features of Bonds Payable Partial-Period Interest Amounts. Alphabet, Inc. ’s accounting year end is December 31, so at year-end Google must accrue interest and amortize bond discount for four months as follows: Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -47

3 Account for Other Features of Bonds Payable Should We Retire Bonds Before Maturity? • Reasons to retire early • Relieve the pressure of high interest payments • May be able to borrow at a lower rate • Callable bonds • Issuer may pay off at a prearranged price whenever issuer chooses • Creates gain or loss Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -48

3 Account for Other Features of Bonds Payable Southwest has $300 million of debenture bonds outstanding. The unamortized discount is $30 million and the bonds are callable at 101. If the market price of the bonds is 99, will Southwest call the bonds at 101 or purchase them for 99 in the open market? Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -49

3 Account for Other Features of Bonds Payable Convertible Bonds and Notes • Bonds may be converted into stock • Investors benefit from: • • Assured receipt of interest and principal on the bonds • Potential for gains on stock Very attractive to investors, often accept lower interest rate Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -50

3 Account for Other Features of Bonds Payable Convertible Bonds and Notes. Southwest has convertible notes payable of $100 million. Assume the note holders convert notes into four million shares of Southwest’s common stock ($1 par) on May 14. Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -51

4 Learning Objective Four Describe other long-term liabilities Copyright © 2019 Pearson Education, Inc.

4 Describe Other Long. Term Liabilities • Most public companies maintain two sets of accounting records: • One for financial reporting • One for tax reporting • Having two sets of records is a legal requirement • Two different sets of records result in timing differences between the financial reporting set and the tax reporting set. • The timing difference can result in a liability, Deferred income taxes Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -53

4 Describe Other Long. Term Liabilities Deferred Income Taxes • • Income tax expense (provision for federal income taxes) • Helps measure net income • Is based on U. S. GAAP Income taxes payable • Current liability on the balance sheet • Represents the amount of income tax a company will pay to the federal government • For almost all companies, income tax expense and income tax payable differ Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -54

4 Describe Other Long. Term Liabilities Assume Southwest’s pretax accounting income is $2, 500 million, and its income tax rate is 40%. On December 31, 2018, the company would record its income tax expense and income tax payable as equal amounts. Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -55

4 Describe Other Long. Term Liabilities Southwest’s financial statements (partial) for fiscal 2018 would report these figures (in millions) Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -56

4 Describe Other Long. Term Liabilities Commitments • Contractual promises to make transactions in the future that create financial obligations for a company • Companies are obligated to disclose to shareholders and creditors in the footnotes to financial statements Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -57

4 Describe Other Long. Term Liabilities Leases • Allow businesses to use an asset without having to purchase it up-front • Finance leases enable the company leasing the asset to own it after a period of time • Operating leases allow the company leasing the asset to use it but not eventually own it Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -58

4 Describe Other Long. Term Liabilities New FASB standard for leases • Goes into effect for public companies in December 2018 and nonpublic companies in 2019 • Requires finance and operating leases longer than 12 months to be capitalized – put on the balance sheet • May significantly increase long-term debt and total assets • May increase debt ratio and decrease ROA Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -59

5 Learning Objective Five Analyze the impact of leverage on the financial statements Copyright

5 Analyze the Impact of Leverage on the Financial Statements The Leverage Ratio Measures the proportion of total liabilities to total assets Known as the equity multiplier, ratio shows a company’s total assets per dollar of stockholders’ equity Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -61

5 Analyze the Impact of Leverage on the Financial Statements Leverage Ratio comparison of

5 Analyze the Impact of Leverage on the Financial Statements Times-Interest-Earned Ratio • Measures the number of times that operating income can cover interest expense • Also called the interest-coverage ratio Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -63

6 Learning Objective Five Report long-term liabilities on the financial statements Copyright © 2019

6 Report long-term liabilities on the financial statements Exhibit 9 -8|Reporting the Liabilities of

Report Long-Term Liabilities on the Financial Statements Disclosing the Fair Value of Long-Term Debt 6 • U. S. GAAP encourage companies to report the fair value of long-term debt • Fair values are based on quoted market prices • Quoted market prices fluctuate, therefore, fair values can either exceed or be less than their carrying amounts Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -66

6 Report long-term liabilities on the financial statements Exhibit 9 -9|Consolidated Statement of Cash Flows (partial, adapted) for Southwest Airlines Co. Copyright © 2019 Pearson Education, Inc. All rights reserved. 9 -67

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