Accounting for LongTerm Liabilities Chapter 10 John J
Accounting for Long-Term Liabilities Chapter 10 John J. Wild Financial Accounting Fundamentals 5 th Edition Copyright © 2016 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw -Hill Education.
10 -A 1: Bond Financing 2
14 - 3 Bond Financing Transactions during the bond life Bond Interest Payments Corporation A 1 Bond Issue Date Bond Interest Payments Investors Interest Payment = Bond Par Value × Stated Interest Rate x Time 3
14 - 4 Bond Financing Advantages Disadvantages Bonds do not affect owner control. Bonds require payment of both periodic interest and par value at maturity. Interest on bonds is tax deductible. Bonds can increase return on equity. A 1 Bonds can decrease return on equity. 4
14 - 5 Bond Trading Bonds are securities that can be purchased or sold in the securities markets. They have a market value which is expressed as a percent of their par value. The closing price indicates that the IBM stock is being sold at 121. 18% of face value. A 1 5
14 - 6 Bond Issuing Procedures A 1 6
10 -P 1: Issuing Bonds at Par 7
14 - 8 Issuing Bonds at Par On Jan. 1, 2015, a company issued the following bonds: Par Value: $800, 000 Stated Interest Rate: 9% Interest Dates: 6/30 and 12/31 Maturity Date = Dec. 31, 2034 (20 years) P 1 8
14 - 9 Issuing Bonds at Par On June 30, 2015, the issuer of the bond pays the first semiannual interest payment of $36, 000. $800, 000 × 9% × ½ year = $36, 000 This entry is made every six months until the bonds mature. P 1 9
14 - 10 Issuing Bonds at Par On December 31, 2034, the bonds mature and the issuer of the bond pays face value of $800, 000 to the bondholders. P 1 10
14 - 11 Bond Discount or Premium P 1 11
10 -P 2: Issuing Bonds at a Discount 12
14 - 13 Issuing Bonds at a Discount Fila issues bonds with the following provisions: Par Value: $100, 000 Issue Price: 96. 454% of par value Stated Interest Rate: 8% Bond will sell at a discount. Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) } P 2 13
14 - 14 Issuing Bonds at a Discount On Dec. 31, 2015, Fila should record the bond issue. Par value Cash proceeds Discount $ 100, 000 96, 454 * $ 3, 546 *$100, 000 x 96. 454% Contra-Liability Account P 2 14
14 - 15 Issuing Bonds at a Discount Maturity Value P 2 Carrying Value 15
14 - 16 Amortizing a Bond Discount Fila will make the following entry every six months to record the cash interest payment and the amortization of the discount. $3, 546 ÷ 4 periods = $887 (rounded) P 2 $100, 000 × 8% × ½ = $4, 000 16
14 - 17 Amortizing a Bond Discount P 2 These two columns always sum to par value for a discount bond. 17
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 96. 46 or $6, 752. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the discount. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20 X 1; (c ) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20 X 3. Change in Carrying Value $248 / 4 semiannual periods = $62 period Semiannual Period-End (0) 12/31/20 X 1 (1) 06/30/20 X 2 (2) 12/31/20 X 2 (3) 06/30/20 X 3 (4) 12/31/20 X 3 Unamortized Discount $248 186 124 62 0 Discount on Bonds Payable 12/31/20 X 1 248 06/30/20 X 2 12/31/20 X 2 06/30/20 X 3 12/31/20 X 3 0 P 1/P 2 Carrying Value $6, 752 << $7, 000 x. 9646 = $6, 752 6, 814 6, 876 6, 938 $7, 000 Bonds Payable 12/31/20 X 1 7, 000 62 62 12/31/20 X 3 7, 000 18
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 96. 46 or $6, 752. Discount on Bonds Payable 12/31/20 X 1 248 06/30/20 X 2 12/31/20 X 2 06/30/20 X 3 12/31/20 X 3 0 Bonds Payable 12/31/20 X 1 62 62 General Journal 12/31/20 X 1 Cash ($7, 000 x. 9646) Discount on Bonds Payable P 1/P 2 7, 000 12/31/20 X 3 Debit 6, 752 248 7, 000 Credit 7, 000 19
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 96. 46 or $6, 752. Discount on Bonds Payable 12/31/20 X 1 248 06/30/20 X 2 12/31/20 X 2 06/30/20 X 3 12/31/20 X 3 0 Bonds Payable 12/31/20 X 1 62 62 General Journal 06/30/20 X 2 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) 12/31/20 X 2 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) 06/30/20 X 3 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) 12/31/20 X 3 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) P 1/P 2 7, 000 12/31/20 X 3 Debit 342 7, 000 Credit 62 280 342 62 280 20
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 96. 46 or $6, 752. Interest expense = Amount repaid minus amount borrowed 4 payments of $280 $1, 120 1 payment of $7, 000 Total repaid 8, 120 Borrowed 6, 752 Total bond interest expense $1, 368 ÷ 4 = $342 General Journal 06/30/20 X 2 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) 12/31/20 X 2 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) 06/30/20 X 3 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) 12/31/20 X 3 Bond Interest Expense ($280 + $62) Discount on Bonds Payable Cash ($7, 000 x 8% / 2) P 1/P 2 Debit 342 Credit 62 280 342 62 280 21
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 96. 46 or $6, 752. Discount on Bonds Payable 12/31/20 X 1 248 06/30/20 X 2 12/31/20 X 2 06/30/20 X 3 12/31/20 X 3 0 Bonds Payable 12/31/20 X 1 62 62 General Journal 12/31/20 X 3 Bonds Payable Cash P 1/P 2 7, 000 12/31/20 X 3 Debit 7, 000 Credit 7, 000 22
10 -P 3: Issuing Bonds at a Premium 23
14 - 24 Issuing Bonds at a Premium Adidas issues bonds with the following provisions: Par Value: $100, 000 Issue Price: 103. 546% of par value Stated Interest Rate: 12% Bond will sell at a premium. Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) } P 3 24
14 - 25 Issuing Bonds at a Premium On Dec. 31, 2013, Adidas will record the bond issue as: Par value Cash proceeds Premium $ 100, 000 103, 546 * $ 3, 546 *$100, 000 x 103. 546% P 3 Adjunct-Liability Account 25
14 - 26 Issuing Bonds at a Premium Maturity Value Carrying Value P 3 26
14 - 27 Amortizing a Bond Premium Adidas will make the following entry every six months to record the cash interest payment and the amortization of the discount. $3, 546 ÷ 4 periods = $887 (rounded) $100, 000 × 12% × ½ = $6, 000 P 3 27
14 - 28 Amortizing a Bond Premium P 3 28
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of 103. 71 or $7, 260. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the premium. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20 X 1; (c ) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20 X 3. Change in Carrying Value $260 / 4 semiannual periods = $65 period Semiannual Period-End (0) 12/31/20 X 1 (1) 06/30/20 X 2 (2) 12/31/20 X 2 (3) 06/30/20 X 3 (4) 12/31/20 X 3 Unamortized Premium $260 195 130 65 0 Bonds Payable 12/31/20 X 1 12/31/20 X 3 P 3 7, 000 Carrying Value $7, 260 << $7, 000 x 1. 0371 = $7, 260 7, 195 7, 130 7, 065 $7, 000 Premium on Bonds Payable 12/31/20 X 1 06/30/20 X 2 65 12/31/20 X 2 65 06/30/20 X 3 65 12/31/20 X 3 260 0 29
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of 103. 71 or $7, 260. Semiannual payment = $280 ($7, 000 x 8% x ½) Bonds Payable 12/31/20 X 1 12/31/20 X 3 7, 000 Premium on Bonds Payable 12/31/20 X 1 06/30/20 X 2 65 12/31/20 X 2 65 06/30/20 X 3 65 12/31/20 X 3 General Journal 12/31/20 X 1 Cash ($7, 000 x 1. 0371) Premium on Bonds Payable Debit 7, 260 0 Credit 260 7, 000 Interest expense = Amount repaid minus amount borrowed 4 payments of $280 $1, 120 1 payment of $7, 000 Total repaid 8, 120 Borrowed 7, 260 Total bond interest expense $ 860 ÷ 4 = $215 period P 3 30
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of 103. 71 or $7, 260. Semiannual payment = $280 ($7, 000 x 8% x ½) Bonds Payable 12/31/20 X 1 12/31/20 X 3 7, 000 Premium on Bonds Payable 12/31/20 X 1 06/30/20 X 2 65 12/31/20 X 2 65 06/30/20 X 3 65 12/31/20 X 3 General Journal 06/30/20 X 2 Bond Interest Expense ($280 - $65) Premium on Bonds Payable Cash ($7, 000 x 8% x ½) 12/31/20 X 2 Bond Interest Expense ($280 - $65) Premium on Bonds Payable Cash ($7, 000 x 8% x ½) 06/30/20 X 3 Bond Interest Expense ($280 - $65) Premium on Bonds Payable Cash ($7, 000 x 8% x ½) 12/31/20 X 3 Bond Interest Expense ($280 - $65) Premium on Bonds Payable Cash ($7, 000 x 8% x ½) P 3 Debit 215 65 260 0 Credit 280 215 65 280 31
NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20 X 1, with a par value of $7, 000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of 103. 71 or $7, 260. Semiannual payment = $280 ($7, 000 x 8% x ½) Bonds Payable 12/31/20 X 1 12/31/20 X 3 7, 000 Premium on Bonds Payable 12/31/20 X 1 06/30/20 X 2 65 12/31/20 X 2 65 06/30/20 X 3 65 12/31/20 X 3 General Journal 12/31/20 X 3 Bonds Payable Cash P 3 Debit 7, 000 260 0 Credit 7, 000 32
14 - 33 Bond Pricing Cash Outflows related to Interest Payments Cash Outflows for par value at end of Bond life P 3 33
14 - 34 Present Value of a Discount Bond Fila issues bonds with the following provisions: Par Value: $100, 000 Issue Price: ? Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) P 3 34
14 - 35 Present Value of a Discount Bond To calculate Present Value, we need relevant interest rate and number of periods. Semiannual rate = 5% (Market rate 10% ÷ 2) Semiannual periods = 4 (Bond life 2 years × 2) $100, 000 × 8% × ½ = $4, 000 P 3 35
10 -P 4: Bond Retirement 36
14 - 37 Bond Retirement of the Fila bonds at maturity for $100, 000 cash. Because any discount or premium will be fully amortized at maturity, the carrying value of the bonds will be equal to par value. P 4 37
14 - 38 Bond Retirement of Bonds before Maturity Carrying Value > Retirement Price = Gain Carrying Value < Retirement Price = Loss Assume that $100, 000 of callable bonds will be retired on July 1, 2015, after the first interest payment. The bond carrying value is $104, 500. The bonds have a call premium of $3, 000. P 4 38
14 - 39 Bond Retirement Conversion of Bonds to Stock On January 1, $100, 000 par value bonds of Converse, with a carrying value of $100, 000, are converted to 15, 000 shares of $2 par value common stock. P 4 15, 000 shares × $2 par value per share 39
10 -C 1: Installment Notes 40
14 - 41 Long-Term Notes Payable Cash Company Note Payable Lender When is the repayment of the principal and interest going to be made? Note Date C 1 Note Maturity Date 41
14 - 42 Long-Term Notes Payable Single Payment of Principal plus Interest Company Lender Single Payment of Principal plus Interest Note Date C 1 Note Maturity Date 42
14 - 43 Long-Term Notes Payable Regular Payments of Principal plus Interest Company Lender Regular Payments of Principal plus Interest Note Date C 1 Note Maturity Date 43
14 - 44 Installment Notes On January 1, 2015, Foghog borrows $60, 000 from a bank to purchase equipment. It signs an 8% installment note requiring 6 annual payments of principal plus interest. Compute the periodic payment by dividing the face amount of the note by the present value factor. C 1 44
14 - 45 Installment Notes with Equal Payments C 1 45
14 - 46 Installment Notes with Equal Payments Let’s record the first payment made on December 31, 2015 by Foghog to the bank. Refer back to the amortization schedule to make the December 31, 2016 payment on the note. C 1 46
14 - 47 Mortgage Notes and Bonds A mortgage is a legal agreement that helps protect the lender if the borrower fails to make the required payments. It gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. C 1 47
NEED-TO-KNOW On January 1, 20 X 1, a company borrows $1, 000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20 X 1 through 20 X 4. 1. Compute the amount of each of the four equal total payments. $1, 000 = Present Value of an Ordinary Annuity $1, 000 = PVA (n=4, i=5%) x Payment $1, 000 PVA (n=4, i=5%) = Payment PV of $1 FV of $1 PV Ord Ann FV Ord Ann C 1/P 5 48
C 1/P 5 49
NEED-TO-KNOW On January 1, 20 X 1, a company borrows $1, 000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20 X 1 through 20 X 4. 1. Compute the amount of each of the four equal total payments. $1, 000 = Present Value of an Ordinary Annuity $1, 000 = PVA (n=4, i=5%) x Payment $1, 000 PVA (n=4, i=5%) C 1/P 5 = Payment $1, 000 3. 5460 = Payment $282 = Payment PV of $1 FV of $1 PV Ord Ann FV Ord Ann 50
NEED-TO-KNOW On January 1, 20 X 1, a company borrows $1, 000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20 X 1 through 20 X 4. $282 1. Compute the amount of each of the four equal total payments. 2. Prepare an amortization table for this installment note. (A) Beginning Balance Period End 12/31/20 X 1 12/31/20 X 2 12/31/20 X 3 12/31/20 X 4 $1, 000 768 524 268 (B) Debit Interest Expense [5% x (A)] $50 38 26 14 $128 (C) Debit Notes Payable [(D) - (B)] $232 244 256 268 $1, 000 (D) Credit Cash $282 282 $1, 128 (E) Ending Balance [(A) - (C)] $768 524 268 0 3. Prepare journal entries to record the loan on January 1, 20 X 1, and the four payments from December 31, 20 X 1, through December 31, 20 X 4. C 1/P 5 51
NEED-TO-KNOW (A) Beginning Balance Period End 12/31/20 X 1 12/31/20 X 2 12/31/20 X 3 12/31/20 X 4 $1, 000 768 524 268 (B) (C) Debit Interest Notes Expense Payable [5% x (A)] [(D) - (B)] $50 $232 38 244 26 256 14* 268 General Journal 01/01/20 X 1 12/31/20 X 2 12/31/20 X 3 12/31/20 X 4 C 1/P 5 Cash Notes payable (D) Credit Cash (E) Ending Balance [(A) - (C)] $282 282 $768 524 268 0 Debit 1, 000 Credit 1, 000 Interest expense Notes payable Cash ($1, 000 x. 05) Interest expense Notes payable Cash ($768 x. 05) Interest expense Notes payable Cash ($524 x. 05) Interest expense Notes payable Cash (* Rounded) 50 232 282 38 244 282 26 256 282 14 268 282 52
14 - 53 Global View Accounting for Bonds and Notes The definitions and characteristics of bonds and notes are broadly similar for both U. S. GAAP and IFRS. The accounting for issuances of bonds, market pricing, and retirement of both bonds and notes is similar. Both U. S. GAAP and IFRS also allow companies to account for bonds and notes using fair value. Accounting for Leases and Pensions Both U. S. GAAP and IFRS require companies to distinguish between operating leases and capital leases; with IFRS calling the latter finance leases. The accounting and reporting for leases are broadly similar, with the main difference that the criteria for identifying a lease as a capital or finance lease is more general under IFRS. For pensions, the methods of accounting and reporting are similar for both U. S. GAAP and IFRS. 53
10 -A 2: Features of Bonds and Notes 54
14 - 55 Features of Bonds and Notes Secured and Unsecured Term and Serial A 2 Convertible and Callable Registered and Bearer 55
10 -A 3: Debt-to-Equity Ratio 56
14 - 57 Debt-to-Equity Ratio Debt-toequity ratio = Total liabilities Total equity This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity. A 3 57
10 -C 2: Present Values of Bonds and Notes 58
14 - 59 Appendix 10 A: Present Values of Bonds and Notes Present Value of $1 Rate Periods 3% 4% 1 0. 9709 0. 9615 2 0. 9426 0. 9246 3 0. 9151 0. 8890 4 0. 8885 0. 8548 5 0. 8626 0. 8219 6 0. 8375 0. 7903 7 0. 8131 0. 7599 8 0. 7894 0. 7307 9 0. 7664 0. 7026 10 0. 7441 0. 6756 C 2 5% 0. 9524 0. 9070 0. 8638 0. 8227 0. 7835 0. 7462 0. 7107 0. 6768 0. 6446 0. 6139 Face amount = $100, 000 Contract rate = 8% Market rate = 10% Interest paid semiannually First, we calculate the present value of the principal repayment in 4 periods (2 years × 2 payments per year, using 5% market rate (10% annual rate ÷ 2 payments per year). $100, 000 × 0. 8227 = $82, 270 59
14 - 60 Appendix 10 A: Present Values of Bonds and Notes Semiannual Interest Annuity $100, 000 × 8% × ½ = $4, 000 × 3. 5460 = $14, 184 C 2 Amount Principal $ 100, 000 Interest 4, 000 Issue price of debt Present Value of Annuity of $1 Rate Periods 3% 4% 5% 1 0. 9709 0. 9615 0. 9524 2 1. 9135 1. 8861 1. 8594 3 2. 8286 2. 7751 2. 7232 4 3. 7171 3. 6299 3. 5460 5 4. 5797 4. 4518 4. 3295 6 5. 4172 5. 2421 5. 0757 7 6. 2303 6. 0021 5. 7864 8 7. 0197 6. 7327 6. 4632 9 7. 7861 7. 4353 7. 1078 10 8. 5302 Present 8. 1109 7. 7217 PV Factor 0. 8227 3. 5460 Value $ 82, 270 14, 184 $ 96, 454 60
10 -P 5: Effective Interest Amortization of a Discount Bond 61
14 - 62 Appendix 10 B: Effective Interest Amortization of Bond Discount Stated Rate: 8% Effective Rate: 10% P 5 62
10 -P 6: Effective Interest Amortization of a Premium Bond 63
14 - 64 Appendix 10 B: Effective Interest Amortization of Bond Premium Stated Rate: 12% Effective Rate: 10% P 6 64
10 -C 3: Issuing Bonds between Interest Dates 65
14 - 66 Appendix 10 C: Issuing Bonds Between Interest Dates Avia sells $100, 000 of its 9% bonds at par on March 1, 2015, 60 days after the stated issue date. The interest on Avia bonds is payable semiannual on each June 30 and December 31. Stated Issue date 1/1 Date of sale 3/1 $1, 500 accrued Bondholder pays $1, 500 to issuer C 3 First Interest date 6/30 $3, 000 earned Issuer pays $4, 500 to bondholder 66
10 -C 4: Leases and Pensions 67
14 - 68 Appendix 10 D: Leases and Pensions A lease is a contractual agreement between the lessor (asset owner) and the lessee (asset renter or tenant) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. Operating Leases Operating leases are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. Examples include most car and apartment rental agreements. Capital Leases Capital leases are long-term (or non-cancelable) leases by which the lessor transfers substantially all risks and rewards of ownership to the lessee. Examples include leases of airplanes and department store buildings. C 4 68
14 - 69 Appendix 10 D: Leases and Pensions A pension is a contractual agreement between an employer and its employees for the employer to provide benefits (payments) to employees after they retire. Defined Benefit Plans The employer’s contributions vary, depending on assumptions about future pension assets and liabilities. A pension liability is reported when the accumulated benefit obligation is more than the plan assets, a so-called underfunded plan. C 4 69
14 - 70 End of Chapter 10 70
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