Chapter Three LongTerm Liabilities 1 Bonds Payable Longterm

Chapter Three Long-Term Liabilities 1

Bonds Payable Long-term debt consist of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Examples: ► Bonds payable ► Long-term notes payable ► Pension liabilities ► Mortgages payable ► Lease liabilities Long-term debt has various covenants or restrictions. 2

Issuing Bonds u Bond contract known as a bond indenture. u Represents a promise to pay: (1) sum of money at designated maturity date, plus (2) periodic interest at a specified rate on the maturity amount (face value). u Bonds are evidenced by paper certificate, typically a $1, 000 face value. u Interest payments usually made semiannually. u Used when the amount of capital needed is too large for one lender to supply. 3

Types and Ratings of Bonds Common types found in practice: 4 u Secured and Unsecured (debenture) bonds. u Term, Serial, and Callable bonds. u Convertible, Commodity-Backed, (Zero-interest debenture bonds). u Registered and Bearer (Coupon) bonds. u Income and Revenue bonds. Deep-Discount bonds

Valuation of Bonds Payable Issuance and marketing of bonds to the public: 5 u Usually takes weeks or months. u Issuing company must ► Arrange for underwriters. ► Obtain SEC approval of the bond issue, undergo audits, and issue a prospectus. ► Have bond certificates printed.

Valuation of Bonds Payable Selling price of a bond issue is set by the u supply and demand of buyers and sellers, u relative risk, u market conditions, and u state of the economy. Investment community values a bond at the present value of its expected future cash flows, which consist of (1) interest and (2) principal. 6

Valuation of Bonds Payable Interest Rate u u Stated, coupon, or nominal rate = Rate written in the terms of the bond indenture. ► Bond issuer sets this rate. ► Stated as a percentage of bond face value (par). Market rate or effective yield = Rate that provides an acceptable return commensurate with the issuer’s risk. ► Rate of interest actually earned by the bondholders. How do you calculate the amount of interest that is actually paid to the bondholder each period? (Stated rate x Face Value of the bond) How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds? 7 (Market rate x Carrying Value of the bond)

Valuation of Bonds – Discount and Premium Calculating the Selling Price of a Bond 1 - Depends on Market Rate of interest 2 - Computation of selling price: - PV of maturity value, plus - PV of interest payments, at what rate? - Market rate of interest 3 - Semi-annual interest paying bonds: - Require doubling the periods - Halving the interest rate 8

Valuation of Bonds Payable Assume Stated Rate of 8% 9 Market Interest Bonds Sold At 6% Premium 8% Par Value 10% Discount

Bonds Issued at Par Illustration Three year bonds are issued at face value of $100, 000 on Jan. 1, 2007, with a stated interest rate of 8%. Interest paid annually on Dec. 31. The market interest rate was 8%. 10 1) Calculate the issue price of the bonds, 2) Make journal entries

Bonds Issued at Par Journal entries for 2007: 1/1/07 Cash 100, 000 Bonds payable 12/31/07 11 100, 000 Interest expense 8, 000 Cash 8, 000

Bonds Issued at Par on Interest Date Illustration: Buchanan Company issues at par 10 -year term bonds with a par value of $800, 000, dated January 1, 2012, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the following entry. Journal entry on date of issue, Jan. 1, 2012. Cash 800, 000 Bonds payable 800, 000 Journal entry to record first semiannual interest payment on July 1, 2012. Interest expense 40, 000 Cash 40, 000 ($800, 000 x. 10 x ½) Journal entry to accrue interest expense at Dec. 31, 2012. Interest expense 40, 000 12 Interest payable 40, 000

Bond Discount and Bond Premiums are amortized using two methods: 1. Straight-line method 2. Effective-Interest method Effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. 13

Bonds Issued at a Discount Illustration Three year bonds are issued at face value of $100, 000 on Jan. 1, 2007, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 10%. Market Rate 10% (PV for 3 periods at 10%) 14

Bonds Issued at a Discount * * rounding Journal entries for 2007: 1/1/07 12/31/07 15 Cash 95, 027 Discount on bonds payable Bonds payable 4, 973 100, 000 Interest expense 9, 503 Discount on bonds payable 1, 503 Cash 8, 000

Bonds Issued at a Discount on Interest Date Illustration: Buchanan Company issues at 97, 10 -year term bonds with a par value of $800, 000, dated January 1, 2012, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the issuance as follows. Cash ($800, 000 x. 97) Discount on bonds payable Bonds payable 16 776, 000 24, 000 800, 000

Bonds Issued at a Discount on Interest Date Illustration: Buchanan records the first semiannual interest payment and the bond discount on July 1, 2012 as follows. Buchanan amortizes the bond discount using the straightline method. Interest expense 41, 200 Discount on bonds payable 1, 200 Cash 40, 000 At Dec. 31, 2012, Buchanan makes the following adjusting entry. Interest expense Discount on bonds payable Interest payable 17 41, 200 40, 000

Bonds Issued at a Premium Illustration Three year bonds are issued at face value of $100, 000 on Jan. 1, 2007, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market interest rate of 6%. Market Rate 6% (PV for 3 periods at 6%) 18

Bonds Issued at a Premium Journal entries for 2007: 19 1/1/07 Cash 105, 346 Premium on bonds payable 5, 346 Bonds payable 100, 000 12/31/07 Interest expense Premium on bonds payable Cash 6, 321 1, 679 8, 000

Bonds Issued at a Premium on Interest Date Illustration: Now assume Buchanan Company issues at 103, 10 year term bonds with a par value of $800, 000, dated January 1, 2012, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the issuance as follows. Cash ($800, 000 x 1. 03) Premium on bonds payable Bonds payable 20 824, 000 800, 000

Bonds Issued at a Premium on Interest Date Illustration: Buchanan records the first semiannual interest payment and the bond discount on July 1, 2012 as follows. Buchanan amortizes the bond premium using the straightline method. Interest expense Premium on bonds payable 38, 800 1, 200 Cash 40, 000 At Dec. 31, 2012, Buchanan makes the following adjusting entry. Interest expense Premium on bonds payable 21 Interest payable 38, 800 1, 200 40, 000

Bonds Issued between Interest Dates v Bond investors will pay the seller the interest accrued from the last interest payment date to the date of issue. v On the next semiannual interest payment date, bond investors will receive the full six months’ interest payment. Illustration: on March 1, 2012, Taft Corporation issues 10 -year bonds, dated January 1, 2012, with a par value of $800, 000. These bonds have an annual interest rate of 6 percent, payable semiannually on January 1 and July 1. Taft records the bond issuance at par plus accrued interest as follows. Cash 808, 000 Bonds payable Interest expense ($800, 000 x. 06 x 2/12) 800, 000 8, 000 On July 1, 2012, four months after the date of purchase, Taft pays the purchaser six months’ interest, by making the following entry. Interest expense 24, 000 22 Cash 24, 000

Effective-Interest Method Effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. 23

Effective-Interest Method Bonds Issued at a Discount Illustration: Evermaster Corporation issued $100, 000 of 8% term bonds on January 1, 2012, due on January 1, 2017, with interest payable each July 1 and January 1. Investors require an effectiveinterest rate of 10%. Calculate the bond proceeds. 24

Effective-Interest Method 25

Effective-Interest Method Journal entry to record first payment and amortization of the discount on July 1, 2012. Interest expense 4, 614 Discount on bonds payable 614 Cash 4, 000 Journal entry to record accrued interest and amortization of the discount on Dec. 31, 2012. Interest expense Interest payable Discount on bonds payable 26 4, 645 4, 000 645

Effective-Interest Method Bonds Issued at a Premium Illustration: Evermaster Corporation issued $100, 000 of 8% term bonds on January 1, 2012, due on January 1, 2017, with interest payable each July 1 and January 1. Investors require an effectiveinterest rate of 6%. Calculate the bond proceeds. 27

Effective-Interest Method 28

Effective-Interest Method Journal entry on date of issue, Jan. 1, 2012. Cash 108, 530 Premium on bonds payable 8, 530 Bonds payable 100, 000 Journal entry to record first payment and amortization of the premium on July 1, 2012. Interest expense Premium on bonds payable Cash 29 3, 256 744 4, 000

Effective-Interest Method Accrued Interest What happens if Evermaster prepares financial statements at the end of February 2012? In this case, the company prorates the premium by the appropriate number of months to arrive at the proper interest expense, as follows. Evermaster records this accrual as follows. Interest expense Premium on bonds payable 30 Interest payable 1, 085. 33 248. 00 1, 333. 33

Effective-Interest Method Classification of Discount and Premium Companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond. Discount on bonds payable is a liability valuation account, that reduces the face amount of the related liability (contra-account). Premium on bonds payable is a liability valuation account, that adds to the face amount of the related liability (adjunct account). 31

Effective-Interest Method Cost of Issuing Bonds Unamortized bond issue costs are treated as a deferred charge and amortized over the life of the debt using straight-line method. Illustration: Microchip Corporation sold $20, 000 of 10 year debenture bonds for $20, 795, 000 on January 1, 2012 (also the date of the bonds). Costs of issuing the bonds were $245, 000. Microchip records the issuance of the bonds and amortization of the bond issue costs as follows. 20, 550, 000 Jan. 1, Cash Unamortized bond issue costs 245, 000 2012 Premium on bonds payable Bonds payable Dec. 1, 32 2012 Bond issue expense 795, 000 20, 000 24, 500 Unamortized bond issue costs 24, 500

Extinguishment of Debt Extinguishment before Maturity Date Reacquisition price > Net carrying amount = Loss Net carrying amount > Reacquisition price = Gain At time of reacquisition, unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date. Illustration Three year 8% bonds of $100, 000 issued on Jan. 1, 2007, are recalled at 105, 000 on Dec. 31, 2008. Expenses of recall are $2, 000. Market interest on issue date was 8%. 33

Extinguishment of Debt Account Balances at Dec. 31, 2008: Bonds payable = $98, 183 Discount on bonds payable ($4, 973– 1, 503 -1, 653) = 1, 817 Journal entry at Dec. 31, 2007: Bonds payable Loss on extinguishment Cash Discount on bonds payable 34 Reacquisition price = $105, 000 + 2, 000 = $107, 000 100, 000 8, 817 107, 000 1, 817

Long-Term Notes Payable Accounting is Similar to Bonds u A note is valued at the present value of its future interest and principal cash flows. Company amortizes any discount or premium over the life of the note. Notes Issued at Face Value Example 1: Coldwell, Inc. issued a $100, 000, 4 -year, 10% note at face value to Hills Bank on January 1, 2013, and received $100, 000 cash. The note requires annual interest payments each December 31. Prepare Coldwell’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment. u (a) Cash 100, 000 Notes payable (b) 35 Interest expense Cash ($100, 000 x 10% = $10, 000) 100, 000 10, 000

Notes Issued at Face Value Example 2: Jennifer, Inc. issued a $100, 000, 4 -year, 11% note at face value to Hills Bank on January 1, 2008, and received $100, 000 cash. The note requires annual interest payments each December 31. Prepare Jennifer’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment. (a) (b) 36 Cash Notes payable Interest expense Cash ($100, 000 x 11% = $11, 000) 100, 000 11, 000

Notes Not Issued at Face Value Zero-Interest-Bearing Notes Issuing company records the difference between the face amount and the present value (cash received) as u a discount and amortizes that amount to interest expense over the life of the note. Example: Samson Corporation issued a 4 -year, $75, 000, zerointerest-bearing note to Brown Company on January 1, 2013, and received cash of $47, 663. The implicit interest rate is 12%. Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest. u 37

Zero-Interest-Bearing Notes (a) Cash Discount on Notes Payable 47, 664 27, 336 Notes Payable (b) Interest expense Discount on Notes Payable 38 75, 000 5, 720

Zero-Interest-Bearing Notes Example: Mc. Nabb Corporation issued a 4 -year, $50, 000, zerointerest-bearing note to Reid Company on January 1, 2008, and received cash of $31, 776. The implicit interest rate is 12%. Prepare Mc. Nabb’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of interest. (a) (b) 39 Cash Discount on notes payable Notes payable Interest expense Discount on notes payable ($31, 776 x 12%) 31, 776 18, 224 50, 000 3, 813

Interest-Bearing Notes Example : Mc. Cormick Corporation issued a 4 -year, $40, 000, 5% note to Greenbush Company on Jan. 1, 2013, and received a computer that normally sells for $31, 495. The note requires annual interest payments each Dec. 31. The market rate of interest is 12%. Prepare Mc. Cormick’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 interest. (a) Computer Discount on notes payable 31, 495 8, 505 Notes payable (b) 40 Interest expense 40, 000 3, 779 Cash 2, 000 Discount on notes payable 1, 779

Interest-Bearing Notes Example 2: Larry Byrd Corporation issued a 4 -year, $50, 000, 5% note to Magic Johnson Company on Jan. 1, 2008, and received a computer that normally sells for $39, 369. The note requires annual interest payments each Dec. 31. The market rate of interest is 12%. Prepare Byrd’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 interest. (a) (b) 41 Cash Discount on notes payable Notes payable Interest expense Cash Discount on notes payable 39, 369 10, 631 50, 000 4, 724 2, 500 2, 224

Special Notes Payable Situations Notes Issued for Property, Goods, or Services When exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless: (1) No interest rate is stated, or (2) The stated interest rate is unreasonable, or (3) The face amount is materially different from the current cash price for the same or similar items or from the current fair value of the debt instrument. 42

Special Notes Payable Situations Choice of Interest Rates If a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, the company must approximate an applicable interest rate. Choice of rate is affected by: 43 ► Prevailing rates for similar instruments. ► Factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.

Special Notes Payable Situations Illustration: On December 31, 2012, Wunderlich Company issued a promissory note to Brown Interiors Company for architectural services. The note has a face value of $550, 000, a due date of December 31, 2017, and bears a stated interest rate of 2 percent, payable at the end of each year. Wunderlich cannot readily determine the fair value of the architectural services, nor is the note readily marketable. On the basis of Wunderlich’s credit rating, the absence of collateral, the prime interest rate at that date, and the prevailing interest on Wunderlich’s other outstanding debt, the company imputes an 8 percent interest rate as appropriate in this circumstance. 44

Special Notes Payable Situations Wunderlich records issuance of the note on Dec. 31, 2012, in payment for the architectural services as follows. Building (or Construction in Process) Discount on notes payable 45 Notes Payable 418, 239 131, 761 550, 000

Special Notes Payable Situations 46 Payment of first year’s interest and amortization of the discount. Interest expense 33, 459 Discount on notes payable 22, 459 Cash 11, 000

Mortgage Notes Payable A promissory note secured by a document called a mortgage that pledges title to property as security for the loan. 47 u Most common form of long-term notes payable. u Payable in full at maturity or in installments. u Fixed-rate mortgage. u Variable-rate mortgages.

Off-Balance-Sheet Financing An attempt to borrow monies in such a way to prevent recording the obligations. Different Forms: 48 v Non-Consolidated Subsidiary v Special Purpose Entity (SPE) v Operating Leases

Fair Value Option Companies have the option to record fair value in their accounts for most financial assets and liabilities, including bonds and notes payable. The FASB believes that fair value measurement for financial instruments, including financial liabilities, provides more relevant and understandable information than amortized cost. Non-current liabilities are recorded at fair value, with unrealized holding gains or losses reported as part of net income. Illustrations: Edmonds Company has issued $500, 000 of 6 percent bonds at face value on May 1, 2012. Edmonds chooses the fair value option for these bonds. At December 31, 2012, the value of the bonds is now $480, 000 because interest rates in the market have increased to 8 percent. Bonds Payable 49 Unrealized Holding Gain or Loss—Income 20, 000

Presentation and Analysis of Long-Term Debt Presentation of Long-Term Debt Note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by the creditors, and assets designated or pledged as security. Fair value of the debt should be discloses. Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years. 50

Presentation and Analysis of Long-Term Debt Two ratios that provide information about debt-paying ability and long-run solvency are: Total debt = Debt to total 1. Total assets The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations. Income before income taxes and interest expense 2. Times interest = earned Interest expense Indicates the company’s ability to meet interest payments as they come due. 51