Accounting Principles 6 e Weygandt Kieso Kimmel Prepared

Accounting Principles, 6 e Weygandt, Kieso, & Kimmel Prepared by Marianne Bradford Bryant College John Wiley & Sons, Inc.

CHAPTER 16 LONG-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 a bond-sinking fund. 5 Describe the accounting for long-term notes payable. 6 Contrast the accounting for operating and capital leases. 7 Identify the methods for the presentation and analysis of long-term liabilities.

PREVIEW OF CHAPTER 16 LONG TERM LIABILITIES Bond Basics Why issue bonds? Types of bonds Issuing procedures Trading Market value Accounting for Bond Issues Issuing bonds at face value Discount or premium Issuing bonds at a discount Issuing bonds at a premium Issuing bonds between interest dates Accounting for Bond Retirements Redeeming bonds at maturity Redeeming bonds before maturity Converting bonds into stock Bond sinking funds Accounting for Other Long-Term Liabilities Long-term notes payable Lease liabilities Presentation and Analysis of Long-Term Liabilities Presentation Analysis

Long-term Liabilities l Long-term liabilities are obligations that are expected to be paid after one year. l Long-term liabilities include bonds, long-term notes, and lease obligations.

STUDY OBJECTIVE 1 . . . . 1 Explain why bonds are issued.

Bond Basics l Bonds are a form of interest-bearing notes payable. They are issued by corporations, universities, and governmental agencies. l Bonds, like common stock, can be sold in small denominations (usually a thousand dollars), and as a result, they attract many investors. l 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? From the standpoint of the corporation seeking long-term financing, bonds offer the following advantages over common stock: 1)Stockholder control is not affected. 2)Tax savings result. 3)Earnings per share may be higher.

Disadvantages of Bonds The major disadvantages resulting from the use of bonds are: 1)Interest must be paid on a periodic basis, and 2)Principal (face value) of the bonds must be paid at maturity.

Types of Bonds: Secured and Unsecured (1 Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A mortgage bond is secured by real estate. Registered 2) Unsecured bonds are issued against the general credit of the borrower; they are also called debenture bonds. No ASSET as Collateral Registered

Types of Bonds: Term and Serial Bonds (3 Bonds that mature at a single specified future date are called term bonds. Registered 2002 2001 2000 1999 4) In contrast, bonds that mature in installments are called serial bonds. 2002 Registered 2001 2000 1999

Types of Bonds: Registered and Bearer (5 Registered bonds are issued in the name of the owner and have interest payments made by check to bondholders of record. Registered 6)Bearer or coupon bonds are not Pay to: Joe Smith registered; thus bondholders must send in coupons to receive interest payments. Registered Pay to: Bearer

Types of Bonds: Convertible and Callable (7 Convertible bonds permit bondholders to convert the bonds into common stock at their option. Stock Registered 8)Callable bonds are subject to call and retirement at a stated dollar amount prior to maturity at the option of the issuer. Registered

Issuing Procedures l State laws grant corporations the power to issue bonds. l Within the corporation, approval by both the board of directors and stockholders is usually required. l In authorizing a bond issue, the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate.

Issuing Procedures l The face value is the amount of principal the issuer must pay at the maturity date. l The contractual interest rate, often referred to as the stated rate, is the rate used to determine the amount of cash interest the borrower pays and the investor receives. l The terms of the bond issue are set forth in a formal legal document called a bond indenture. l After the bond indenture is prepared, bond certificates, which provide information such as name of issuer and maturity date, are printed.

Bond Trading l Corporate bonds, like capital stock, are traded on national securities exchanges. Thus, bondholders have the opportunity to convert their holdings into cash at any time by selling the bonds at the current market price. l Bond prices are quoted as a percentage of the face value of the bond (usually $1, 000). l Transactions between a bondholder and other investors are not journalized by the issuing corporation. l 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 l The market value (present value) of a bond is a function of three factors: 1) the dollar amounts to be received 2) the length of time until the amounts are received, and 3) the market rate of interest, which is the rate investors demand for loaning funds. l The process of finding the present value is referred to as discounting the future amounts.

Illustration 16 -5 Time diagram depicting cash flows 100, 000$ 9, 000$ 9, 000$ 5 5 4 3 2 Principal Interest 1 0 year period Assume that Kell Company on January 1, 2002, issues $100, 000 of 9% bonds, due in 5 years, with interest payable annually at year-end. The purchaser of the bonds would receive two cash payments: 1) principal of $100, 000 to be paid at maturity, and 2) five $9, 000 interest payments ($100, 000 x 9%) over the term of the bond.

Illustration 16 -6 Computing the market price of bonds The market value of a bond is equal to the present value of all the future cash payments promised by the bond. The present values of these amounts are shown below: Market price of bonds $100, 000

STUDY OBJECTIVE 2 . . . . 2 Prepare the entries for the issuance of bonds and interest expense.

Accounting for Bond Issues Issuing Bonds at Face Value 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, 2002, at 100 (100% of face value). The entry to record the sale is: 1, 000, 000 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 Issues Issuing Bonds at Face Value Assume that interest is payable semiannually on January 1 and July 1 on the bonds, interest of $45, 000 ($1, 000 x 9% x 6/12)must be paid on July 1, 2002. The entry for the payment is: 45, 000

Accounting for Bond Issues Issuing Bonds at Face Value At December 31, an adjusting entry is required to recognize the $45, 000 of interest expense incurred since July 1. The entry is: 45, 000 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, 2003, Bond Interest Payable is debited, and Cash is credited for $45, 000 in order to eliminate the liability.

Accounting for Bond Issues Discount or Premium on Bonds l Bonds may be issued below or above face value. l If the 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. l If the market rate of interest is less than the contractual rate on the bonds, the bonds will sell above face value, or at a premium.

Illustration 16 -7 Interest rates and bond prices Issued when: BOND CONTRACTUAL INTEREST RATE 10% Market Rates Bonds Sell at: 8% Premium 10% Face Value 12% Discount

Issuing Bonds at a Discount Assume that on January 1, 2002, 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: 92, 639 7, 361 100, 000

Illustration 16 -8 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, which is deducted from bonds payable on the balance sheet, as illustrated below: 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.

Illustration 16 -9 Total cost of borrowing - bonds issued at discount l 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. l The total cost of borrowing, $92, 639 for Candlestick, Inc. , is $57, 361, as computed as follows:

Illustration 16 -10 Alternative computation of total cost of borrowing - bonds issued at discount Alternatively, the total cost of borrowing can be computed as follows: Total cost of borrowing $57, 361

Illustration 16 -11 Formula for straight-line method of bond discount amortization l To comply with the matching principle, bond discount should be allocated systematically to each accounting period that benefits from the use of the cash proceeds. l One method is the straight-line method of amortization. It allocates the same amount to interest expense each interest period. l The amount is determined as follows: Bond Discount / Number of Interest Periods = Bond Discount Amortization

Amortizing Bond Discount In the previous example, the bond discount amortization is $736 ($7, 361 /10 periods). The entry to record the payment of bond interest and the amortization of bond discount on the first interest date (July 1, 2002) is: 5, 736 5, 000

Amortizing Bond Discount Entries At December 31, the adjusting entry is: 5, 736 5, 000 Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity. Thus, the carrying value of the bonds at maturity will be equal to the face value.

Issuing Bonds at a Premium The issuance of bonds at a premium we now assume the Candlestick, Inc. bonds described above are sold for $108, 111 (108. 111% of face value) rather than for $ 92. 639. 108, 111 100, 000 8, 111

Illustration 16 -13 Statement presentation of bond premium Premium on bonds payable is added to bonds payable on the balance sheet, as shown below: Add: Premium on bonds payable

Illustration 16 -14 Total cost of borrowing-bonds issued at a premium 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.

Illustration 16 -15 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

Illustration 16 -16 Formula for straight-line method of bond premium amortization l The formula for determining bond premium amortization under the straight -line method is: Bond Premium / Number of Interest Periods = Bond Premium Amortization

Amortizing Bond Premium The premium amortization for each interest period is $811 ($8, 111 / 10). The entry to record the first payment of interest on July 1 is: 4, 189 811 5, 000

Amortizing Bond Premium At December 31, the adjusting entry is: 4, 1 811 5, 000 Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity date of the bonds.

Issuing Bonds between Interest Dates When bonds are issued between interest payment dates, the issuer requires the investor to pay the market price for the bonds plus accrued interest since the last interest date. To illustrate, assume that Deer Corporation sells $1, 000, 9% bonds at face value plus accrued interest on March 1. Interest is payable semiannually on July 1 and January 1. The accrued interest is $15, 000 ($1, 000 x 9% x 2/12). The total proceeds on the sale of the bonds, therefore, are $1, 015, 000. The entry to record the sale is: 1, 015, 000 1, 000 15, 000

Issuing Bonds between Interest Dates At the first interest date, it is necessary to (1) eliminate the bond interest payable balance and (2) recognize interest expense for the 4 months (March 1 - June 30) the bonds have been outstanding. Interest expense is $30, 000 ($1, 000 x 9% x 4/12). The entry on July 1 for the $45, 000 interest payment is: 15, 000 30, 000 45, 000

STUDY OBJECTIVE 3 . . . . 3 Describe the entries when bonds are redeemed or converted.

Redeeming Bonds at Maturity Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the interest for the last interest period is paid and recorded separately, the entry to record the redemption of the Candlestick bonds at maturity is: 1, 000, 000

Bond Retirements l Bonds may be redeemed before maturity because a company may decide to reduce interest cost and remove debt from its balance sheet. l When bonds are retired before maturity it is necessary to: 1)Eliminate the carrying value of the bonds at the redemption date, 2)Record the cash paid, and 3)Recognize the gain or loss on redemption. l A gain (loss) is reported as an extraordinary item in the income statement.

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 $1, 004, 000. The entry to record the redemption at the end of the eighth interest period (January 1, 2006) is: 1, 000 26, 000 1, 030, 000 4,

Converting Bonds into Common Stock In recording the conversion of bonds into common stock the current market prices of the bonds and the stock are ignored. Instead, the carrying value of the bonds is transferred to paid-in capital accounts. No gain or loss is recognized. Assume that on July 1 Saunders Associates converts $100, 000 bonds sold at face value into 2, 000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130, 000. The entry to record the conversion is: 100, 000 20, 000 80, 000

STUDY OBJECTIVE 4 . . . . 4 Describe a bond-sinking fund.

Bond Sinking Funds l A sinking fund is cash or other assets set aside to retire debt. l A sinking fund makes the bonds more attractive to investors, because it enhances the likelihood that the bonds will be redeemed at maturity. l A trustee, such as a bank or trust company, usually controls the funds and invests them. l A bond sinking fund is reported as a single amount in the investment section of the balance sheet.

STUDY OBJECTIVE 5 . . . . 5 Describe the accounting for long-term notes payable.

Accounting for Other Long-Term Liabilities l Long-term notes payable are similar to short-term interest-bearing notes payable except that the term of the note exceeds one year. l A long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan. l Mortgage notes payable are widely used by individuals to purchase homes and to acquire plant assets by many small and some large companies. l Mortgage notes payable are recorded initially at face value. Subsequent entries are required for each installment payment.

Illustration 16 -18 Mortgage installment payment schedule To illustrate, assume that Porter Technology Inc. issues a $500, 000, 12%, 20 -year mortgage note on December 31, 2002, to obtain needed financing for the construction of a new research laboratory. The terms provide for semiannual installment payment of $33, 231. The installment payment schedule for the first year is shown below: $500, 000 Issue date 1 $33, 231 $30, 000 $3, 231 496, 769 2 $33, 231 29, 806 3, 425 493, 344

Long-term Notes Payable Entries The entries to record the mortgage loan and first installment payment (per schedule on previous slide) are as follows: 500, 000 30, 000 3, 231 33, 231

STUDY OBJECTIVE 6 . . . . 6 Contrast the accounting for operating and capital leases.

Operating Leases l In an operating lease the intent is temporary use of the property by the lessee. The lessor continues to own the property. l The lease (or rental) payments are recorded as an expense by the lessee and as revenue by the lessor. Car rental is an example of an operating lease

Capital Leases l In a capital lease the present value of the cash payments for the lease are capitalized and recorded as an asset. A capital lease is in substance an installment purchase by the lessee. l The lessee must record the lease as an asset (a capital lease) if any one of the following conditions exist: a) The lease transfers ownership of the property to the lessee. b) The lease contains a bargain purchase option. c) The lease term is equal to 75% or more of the economic life of the leased property. d) The present value of the lease payments equals or exceeds 90% of the fair market value of the leased property.

Capital Lease Entries Assume that Gonzalez Company decides to lease new equipment. The lease period is 4 years; the economic life of the leased equipment is estimated to be 5 years. The present value of the lease payments is $190, 000, which is equal to the fair market value of the equipment. There is no transfer of ownership during the lease term, nor is there any bargain purchase option. IN THIS EXAMPLE, GONZALEZ HAS ESSENTIALLY PURCHASED THE EQUIPMENT BECAUSE CONDITIONS (3) AND (4) HAVE BEEN MET (SEE PREVIOUS SLIDE). 190, 000

STUDY OBJECTIVE 7 . . . . 7 Identify the methods for the presentation and analysis of long-term liabilities.

Presentation and Analysis of Long-Term Liabilities l The nature and amount of each long-term debt should be reported in the balance sheet or in schedules in the notes accompanying the statements. l The current maturities of long-term debt should be reported under current liabilities if they are to be paid from current assets. l Long-term liabilities are reported in a separate section of the balance sheet immediately following current liabilities.

Illustration 16 -20 Balance sheet presentation of long-term liabilities The long-term liabilities for LAX Corporation are shown below:

Illustration 16 -21 Debt to total assets The debt to total assets ratio measures the percentage of total assets provided by creditors, indicating the degree of leveraging. It is calculated by dividing total debt by total assets. Lands End’s annual report disclosed total liabilities of $160 million and total assets of $456 million. Their debt to total assets ratio is calculated below: TOTAL DEBT TO TOTAL ASSETS = ———— TOTAL ASSETS 35% = 160 / 456

Illustration 16 -21 Times Interest Earned Ratio The times interest earned ratio indicates the company’s ability to meet interest payments as they come due. It is computed by dividing income before income taxes and interest expense by interest expense. Lands End’s annual report disclosed interest expense of $1. 9 million, income taxes of $28. 2 million, and net income of $48 million. The times interest earned ratio is computed below. TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE EARNED = ——————————————— INTEREST EXPENSE 55. 9 times = ($76. 2 + $28. 2 + $1. 9) / $1. 9

STUDY OBJECTIVE 8 . . . . 7 Contrast the effects of the straight-line and effective-interest methods of amortizing bond discount and bond premium.

APPENDIX: Effective-Interest Amortization l The effective-interest method of amortization is an alternative to straight-line amortization. l Both amortization methods result in the same total amount of interest expense over the term of the bonds. l When the amounts are materially different, the effective-interest method is required under GAAP.

Illustration 16 A-2 Computation of amortizationeffective-interest method l Bond interest expense is computed by multiplying the carrying value of the bonds at the beginning of the interest period by the effective-interest rate. l The bond discount or premium amortization is computed by determining the difference between the bond interest expense and the bond interest paid. (1) Bond Interest Expense Carrying value of Bonds x Effective at Beginning Interest of Period Rate (2) Bond Interest Paid Face Contractual Amount x Interest of Bonds Rate Amortization Amount

Illustration 16 A-3 Bond discount amortization schedule Candlestick Inc. issues $100, 000 of 10%, 5 -year bonds on January 1 2002 with interest payable each July 1 and January 1. The bonds will sell for $92, 639 with an effective interest rate of 12%; Therefore, the bond discount is $7, 361 ($100, 000 - $92, 639). The schedule below facilitates recording of interest expense and discount amortization. NOTE: TABLE WILL CONTINUE FOR 10 SEMIANNUAL PERIODS $7, 361 Issue date $92, 639 1 $5, 000 $5, 558 $ 558 6, 803 93, 197 2 $5, 000 5, 592 6, 211 93, 789

Illustration 16 A-5 Bond premium amortization schedule Candlestick Inc. issues $100, 000 of 10%, 5 -year bonds on January 1 2002 with interest payable each July 1 and January 1. The bonds will sell for $108, 111 with an effective interest rate of 8%; therefore, the bond premium is $8, 111 ($108, 111 -$100, 000). The schedule below facilitates recording of interest expense and premium amortization. NOTE: TABLE WILL CONTINUE FOR 10 SEMIANNUAL PERIODS Issue date $8, 111 $108, 111 1 $5, 000 $4, 324 $676 $7, 435 107, 435 2 5, 000 4, 297 703 6, 732 106, 732

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CHAPTER 16 LONG-TERM LIABILITIES