Financial and Managerial Accounting Wild Shaw and Chiappetta

Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter 10 Long-Term Liabilities

Conceptual Learning Objectives C 1: Explain the types and payment patterns of notes. C 2: Appendix 10 A – Explain and compute the present value of an amount(s) to be paid at a future date(s). C 3: Appendix 10 C – Describe interest accrual when bond payment periods differ from accounting periods. C 4: Appendix 10 D – Describe accounting for leases and pensions (see text for details). 10 -3

Analytical Learning Objectives A 1: Compare bond financing with stock financing. A 2: Assess debt features and their implications. A 3: Compute the debt-to-equity ratio and explain its use. 10 -4

Procedural Learning Objectives P 1: Prepare entries to record bond issuance and interest expense. P 2: Compute and record amortization of bond discount using straight-line method. P 3: Compute and record amortization of bond premium using straight-line method. P 4: Record the retirement of bonds. P 5: Prepare entries to account for notes. P 6: Appendix 10 B- Compute and record amortization of bond discount using effective interest method. P 7: Appendix 10 B- Compute and record amortization of bond premium using effective interest method. 10 -5

A 1 Advantages of Bonds do not affect owner control. Interest on bonds is tax deductible. Bonds can increase return on equity. 10 -6

A 1 Disadvantages of Bonds require payments of both periodic interest and par value at maturity. Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds. 10 -7

A 1 Bond-Issuing Procedures A company can sell the bonds to . . . investors . . . an investment firm called an underwriter, resells the bonds to A trustee monitors the bond issue. 10 -8

A 1 Basics of Bonds Bond Interest Payments Corporation Investors Bond Interest Payments Bond Issue Date Interest payment = Bond par value ´ Contract interest rate x Time 10 -9

P 1 Issuing Bonds at Par King Co. issues the following bonds on January 1, 2013 Par value = $1, 000 Stated interest rate = 10% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2032 (20 years) 10 -10

P 1 Interest Expense on Bonds at Par The entry on June 30, 2013, to record the first semiannual interest payment is. . . Interest payment is: $1, 000 × 10% × ½ year = $50, 000 This entry is made every six months until the bonds mature. 10 -11

P 1 Issuing Bonds at Par On Dec. 31, 2032 when the bonds mature, King Co. makes the following entry. . . The debt has now been extinguished. 10 -12

P 1 Bond Discount or Premium Contract rate Dow Chemical Company $1, 000 8. 875% paid semiannually on 6/30 and 12/31 Due (matures) on 2033 10 -13

P 2 Issuing Bonds at a Discount Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1, 000 Issue price = 92. 6405% of par value Stated interest rate = 10% Bond will sell at a discount. Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) } 10 -14

P 2 Issuing Bonds at a Discount $1, 000 ´ 92. 6405% Amortizing the discount increases interest expense over the outstanding life of the bond. 10 -15

P 2 Issuing Bonds at a Discount On Jan. 1, 2013, Rose Co. would record the bond issue as follows: Bonds Payable 1, 000 Discount on Bonds Payable 73, 595 Contra-Liability Account 10 -16

P 2 Making the First Interest Payment and Amortizing the Discount Maturity Value Using the straight-line method, the discount amortization will be $7, 360 every six months. Carrying Value $73, 595 ÷ 10 periods = $7, 360* *(rounded) 10 -17

P 2 Making the First Interest Payment and Amortizing the Discount Make the following entry every six months to record the cash interest payment and the amortization of the discount. $73, 595 ÷ 10 periods = $7, 360 (rounded) $1, 000 × 10% × ½ = $50, 000 10 -18

P 2 Straight-Line Amortization of Bond Discount 10 -19

P 2 Straight-Line and Effective Methods Interest Periodic interest amounts will differ but total interest expense, over the life of the bond, will be the same. $ Life of the Bond 10 -20

P 3 Issuing Bonds at a Premium Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1, 000 Issue price = 108. 1145% of par value Stated interest rate = 10% Bond will sell at a premium. Market interest rate = 8% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) } 10 -21

P 3 Issuing Bonds at a Premium $1, 000 ´ 108. 1145% Amortizing the premium decreases interest expense over the life of the bond. 10 -22

P 3 Issuing Bonds at a Premium On Jan. 1, 2013, Rose Co. would record the bond issue as follows. Bonds Payable 1, 000, 0 00 Premium on Bonds Payable 81, 145 Adjunct-Liability (or accretion) Account 10 -23

P 3 Making the First Interest Payment and Amortizing the Bond Premium Using the straight-line method, the premium amortization will be $8, 115 every six months. $81, 145 ÷ 10 periods = $8, 115 (rounded) Maturity Value Carrying Value 10 -24

P 3 Making the First Interest Payment and Amortizing the Bond Premium This entry is made every six months to record the cash interest payment and the amortization of the premium. $81, 145 ÷ 10 periods = $8, 115 (rounded) $1, 000 × 10% × ½ = $50, 000 10 -25

P 3 Straight-Line Amortization of Bond Premium 10 -26

P 4 Bond Retirement n n The carrying value of the bond at maturity always equals its par value. Sometimes bonds are retired prior to their maturity. Two common ways to retire bonds before maturity are through the exercise of a callable option or through purchasing them on the open market. Callable bonds present several accounting issues including calculating gains and losses. 10 -27

P 4 Bond Retirement • Before Maturity • • Carrying value > Retirement price = Gain Carrying value < Retirement price = Loss 10 -28

C 1 Long-Term Notes Payable Cash Company Note Payable Lender When is the repayment of the principal and interest going to be made? Note Issuance Date Note Maturity Date 10 -29

C 1 Long-Term Notes Payable Company Single Payment of Principal plus Interest (at maturity) Lender Single Payment of Principal plus Interest Note Issuance Date Note Maturity Date 10 -30

C 1 Long-Term Notes Payable Regular Payments of Principal plus Interest (Over the life of the bond) Lender Company Regular Payments of Principal plus Interest Note Issuance Date Payments can either be equal principal payments plus interest or equal payments. Note Maturity Date 10 -31

C 1, P 5 Installment Notes with Equal Principal Payments Annual payments decrease. The principal payments are $10, 000 each year. Interest expense decreases each year. 10 -32

C 1 Installment Notes with Equal Payments Annual payments are constant. The principal payments increase each year. Interest expense decreases each year. 10 -33

P 5 Mortgage Notes and Bonds n A legal agreement that helps protect the lender if the borrower fails to make the required payments. n 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. 10 -34

A 2 Types of Bonds Secured or Unsecured Convertible and/or Callable Term or Serial Registered or Bearer 10 -35

A 3 Debt-to-Equity Ratio Debt-to. Equity ratio = Total liabilities Total equity A measure to assess the risk of a company’s financing structure. Industries that are more variable and less stable tend to have lower ratios, while more stable industries tend to have higher ratios. 10 -36

C 2 Figuring the Present Value of a Bond Calculate the issue price of Rose Co. ’s bonds. Par value = $1, 000 Issue price = ? Stated interest rate = 10% Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) 10 -37

C 2 Figuring the Present Value of a Bond 1. Semiannual rate = 6% (Market rate 12% ÷ 2) 2. Semiannual periods = 10 (Bond life 5 years × 2) $1, 000 × 10% × ½ = $50, 000 10 -38

P 6, P 7 Effective Interest Method of Amortizing a Discount or Premium n The effective interest method allocates total bond interest expense over a changing carrying value. It yields a constant rate of interest over the life of the bond equal to the market rate at time of issuance. t s e r e t In = e s n Expe Carrying Value of the bond x Market Rate x Time 10 -39

Issuing Bonds between Interest Dates C 3 Jan. 1, 2013 Bond Date Apr. 1, 2013 Bond Issue Date June 30, 2013 First Interest Payment Accrued interest Investor pays bond purchase price + accrued interest. 10 -40

Issuing Bonds between Interest Dates C 3 Jan. 1, 2013 Bond Date Apr. 1, 2013 Bond Issue Date Accrued interest June 30, 2013 First Interest Payment Earned interest Investor receives 6 months’ interest. 10 -41

C 3 Issuing Bonds between Interest Dates Prepare the entry to record the following bond issue by King Co. on Apr. 1, 2013. Par value = $1, 000 Stated interest rate = 10% Market interest rate = 10% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years) 10 -42

C 3 Issuing Bonds between Interest Dates At the date of issue, the following entry is made: The first interest payment on June 30, 2013 is: 10 -43

C 3 Accruing Bond Interest Expense at Year End for a Partial Bond Interest Period. Jan. 1 End of accounting Interest Payment Dates period Apr. 1 Oct. 1 Dec. 31 3 months’ accrued interest At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment. 10 -44

End of Chapter 10 10 -45