LongTerm Liabilities Bonds Payable and Classification of Liabilities

Long-Term Liabilities, Bonds Payable, and Classification of Liabilities on the Balance Sheet Chapter 11 1 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Learning Objectives Journalize transactions for long-term notes payable and mortgages payable Describe bonds payable Measure interest expense on bonds using the straight-line amortization method 2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Where are we now? #3 #1 #2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Defining Liabilities: Debt vs. Equity Assets are financed from two sources: What are they? DEBT / LIABILITIES EQUITY Funds from creditors, with Funds from owners who definite due dates, and specific share in the profits and interest terms. Normally no losses of the company. management role Normally some control. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Defining Liabilities: Debt vs. Equity Relatively small financing needs can be filled from single sources. Loan - Debt Owner investment – Equity Financing Bank Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Defining Liabilities: Debt vs. Equity Large financing needs are often filled by several “investors”. Bond Issue. Debt Stock Issue – Equity financing Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Defining Liabilities: Short Term to Long Term Unearned Revenue Wages Payable Merchandise inventory invoices Interest Payable < 1 year Short Term Assorted Types of Notes Payable Bonds Payable > 1 year Long Term Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The Financing Choice: Debt vs. Equity Debt is better because: Interest rates are typically lower than the return expected by equity investors. Why? Interest rates are capped without the upside of equity. Why share the profits when a little interest payment will do? Interest expense reduces net income so these are effectively pre-tax payments. For a given financing transaction, this leaves more money available for paying higher returns Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The Financing Choice: Debt vs. Equity is better because: The principal, or in this case, the investment doesn’t have to be paid back unlike debt. Dividends to common shareholders are optional. Potential profits don’t have to be paid to lenders, so the stockholders keep it all for themselves. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The Financing Choice: Debt vs. Equity A balance of debt and equity is better because: Too much debt can consume all of a firm’s profits Too little borrowing unnecessarily ties-up owners’ equity that might be more profitably invested in other ventures by the owners. A balanced approach minimizes the firm’s cost of capital. Borrow too much and the rates go up Borrow too little, and you’ll have a hard time meeting owners high ROE expectations. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Where’d he go? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1 Journalize transactions for mortgages payable 16 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Installment Notes Payable eg’s: mortgage, car loan Long-term notes that call for a series of installment payments. Each payment covers interest for the period AND a portion of the principal. With each payment, the interest portion gets smaller and the principal portion gets larger. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Allocating Installment Payments Between Interest and Principal 1) Identify the Unpaid Principal Balance 2) Interest expense= Principal × Interest rate × time 3) Installment payment - Interest expense = Reduction in Principal 4) Compute new unpaid principal balance. 5) Goto 1) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Allocating Installment Payments Between Interest and Principal On January 1, 2009, Rocket Corp. borrowed $7, 581. 57 from First Bank of River City. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2, 000. Prepare an amortization table for Rocket Corp. ’s loan. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Allocating Installment Payments Between Interest and Principal Next, prepare the journal entries for issuing, reclassification, and first interest payment. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Journalizing Installment Payments Find the journal entry numbers on the amortization table! Reduction in Unpaid Balance Interest Expense Payment Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Using data from S 11 -2 to make an amortization table Ethan, Co. took out a $280, 000, 20 year, 6% mortgage payable on January 1, 2013. Fully amortizing monthly payments are $2, 006. Build the first 5 months of their amortization table Do not round any calculations, round display to the dollar. 22 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Amortization Table Fun! Let’s see the whole table Note how: The payment split between interest and principal reduction changes over time Journal entries: Borrowing the money Recognizing short term portion Making a payment Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Amortization Table Misery! How much do payment reductions extend your payoff date? How much do interest rate changes extend your payoff date? How does this all relate to the housing implosion? 20 year mortgage; 30 year mortgage, adjustable rate mortgages, interest only, negative amortization, securitization, bailout Let’s see Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

On January 1, 2014, Le. May-Finn, Co. , signed a $200, 000, fiveyear, 6% note. The loan required Le. May-Finn to make payments on December 31 of $40, 000 principal plus interest. 1. Journalize the issuance of the note on January 1, 2014. 2. Journalize the reclassification of the current portion of the note payable. 3. Journalize the first note payment on December 31, 2014. 25 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Journal Entry ACCOUNTS DATE Jan 1 Cash DATE Jan 1 Long-term notes payable Current portion of long-term notes payable Journal Entry ACCOUNTS DATE Dec 31 Interest expense 200, 000 DEBIT CREDIT 40, 000 DEBIT CREDIT 12, 000 (Current portion of )long-term 26 CREDIT 200, 000 Long-term notes payable Journal Entry ACCOUNTS , DEBIT 40, 000 notes payable (option) Cash 52, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2 Describe bonds payable 27 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bond, Sample Bond $10, 000 9 ¼% DUE 1992 $10, 000 Ten Thousand Dollars 9 ¼% DUE 1992 Dated: February 15, 1972 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bonds can sell for more or less than par value based Interest and risk Bonds may sell or trade for more or less than the par value: A $1, 000 bond that trades for $1, 020 is priced at 102. That’s 2% premium A $1, 000 bond priced at 98 trades for $980. That’s a 2% discount Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Why bond prices fluctuate Assume two bonds: Which would you invest in if you were in the market? Risk (Fitch Rating): Face Value: Maturity: Interest Rate paid: Coffee Co. Bond C Grade Corp. $1, 000 10 yrs 6% Apple Co. Bond A Grade Corp. $1, 000 10 yrs 6% Bond price depends on risk, time to maturity, and interest rate offered by your bond. Real? Yahoo bonds Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bond prices depend on the market rate of interest, stated rate of interest, and time. Determine whether the following bonds payable will be issued at maturity value, at a premium, or at a discount. a. The market interest rate is 6%. Boise, Corp. , issues bonds payable with a stated rate of 5 3/4%. Discount b. Dallas, Inc. , issued 8% bonds payable when the market rate was 7 1/4%. Premium 37 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bond prices depend on the market rate of interest, stated rate of interest, and time. 1. Compute the price of the following 7% bonds of United Telecom. a. $500, 000 issued at 76. 75. $383, 750 b. $500, 000 issued at 104. 75. $523, 750 39 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

3 Measure interest expense on bonds using the straight-line amortization method 40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at Par Value No discount, No premium Cash received equals principal amount of bond Journalize initial bond issue for $100, 000 in 9%, 5 year bonds payable at par value: Interest payments–every 6 months for bond life $100, 000 x 9% x 6/12 = $4, 500 41 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at Par Value At maturity date, the principal is paid back 42 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting for a Bond Discount All payments to the bond holder are still based on the face value of the bond. Why wouldn’t we want to write off the discount as a loss all in the period in which we issued the bond? Use the words “matching principle” in your answer. Face value, market value, carrying value When are these all the same? When are they different? How do they change over time? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at a Discount Jan 1, 2013: $100, 000, 9% bond, sold at 96. 149 The journal entry Bond account balances 47 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at a Discount Balance sheet presentation Immediately after issuance Interest payments–semi-annually $100, 000 X 9% X 6/12 = $4, 500 What happens to the $3, 851 discount? 48 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Journalizing interest payments on discounted bonds The discount is amortized The discount holds the amount on the balance sheet Amortizing converts it to expense during bond life This matches the expense to the use of the funds Straight-line amortization Similar to straight-line depreciation 5 year life at 2 times a year = 10 periods Discount divided by periods = amortized amount The journal entry: 49 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Principal repayment at maturity Interest payments continue over the bond’s life Every 6 months, interest is paid Discount is amortized each payment period, reducing the account At maturity, the Discount account is zero and the carrying value is equal to maturity value At maturity date, the principal is paid back 50 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bond Discount/Premium Process Steps Recording the issuance of the bonds. Step 1: Calculate and Debit the Cash account. Step 2: Credit the liability account bonds payable at face value. Step 3: Debit the account Discount on Bonds Payable OR Credit the account Premium on Bonds Payable Recording the Payments. Step 1: Record cash paid (or accrued interest). Stated rate x face value x time Step 2: Calculate and record the discount or premium amortization. Discount x 1/bond years x fraction of year Final Step: Record the bond interest expense. Use the residual method Retiring bonds. Step 1: Complete entry for the final interest payment Step 2: Record cash paid to settle Bonds Payable liability Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Origin, Inc. issued a $40, 000, 5%, 10 -year bond payable at a price of 90 on January 1, 2012. 1. Journalize the issuance of the bond payable on January 1, 2012. Journal Entry DATE Jan 1 Cash ACCOUNTS Discount on bonds payable Bonds payable 52 DEBIT CREDIT 36, 000 40, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

(Continued) 2. Journalize the payment of semiannual interest and amortization of the bond discount or premium on July 1, 2012, using the straight-line method to amortize the bond discount or premium. Journal Entry ACCOUNTS DATE Jan 1 Interest expense Discount on bonds payable Cash 53 DEBIT CREDIT 1, 200 1, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at a Premium Market interest 8%, bond stated rate 9% Investors pay a premium to acquire these Cash received is more than the face value Issuing journal entry Bond account balances 54 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at a Premium Balance Sheet presentation Immediately after issuance Interest payments–semi-annually $100, 000 X 9% X 6/12 = $4, 500 What happens to the $4, 100 premium? 55 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at a Premium The premium is amortized to offset interest expense Balance sheet holds the premium Amortizing spreads this benefit across bond life The premium reduces Interest expense Straight-line amortization 5 year life at 2 times a year = 10 periods Premium divided by periods = amortized amount The journal entry: 56 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Issuing Bonds Payable at a Premium Interest payments continue over the bond’s life Every 6 months, interest is paid Premium is amortized each payment period, reducing the account At maturity, the Premium account is zero and the carrying value is equal to maturity value At maturity date, the principal is paid back 57 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bond Discount/Premium Process Steps Recording the issuance of the bonds. Step 1: Calculate and Debit the Cash account. Step 2: Credit the liability account bonds payable at face value. Step 3: Debit the account Discount on Bonds Payable OR Credit the account Premium on Bonds Payable Recording the Payments. Step 1: Record cash paid (or accrued interest). Stated rate x face value x time Step 2: Calculate and record the discount or premium amortization. Discount x 1/bond years x fraction of year Final Step: Record the bond interest expense. Use the residual method Retiring bonds. Step 1: Complete entry for the final interest payment Step 2: Record cash paid to settle Bonds Payable liability Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worthington Mutual Insurance Company issued a $50, 000, 5%, 10 year bond payable at a price of 108 on January 1, 2012. 1. Journalize the issuance of the bond payable on January 1, 2012. Journal Entry DATE Jan 1 Cash ACCOUNTS Premium on bonds payable Bonds payable 59 DEBIT CREDIT 54, 000 50, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

(Continued) 2. Journalize the payment of semiannual interest and amortization of the bond discount or premium on July 1, 2012, using the straight-line method to amortize the bond discount or premium. Journal Entry ACCOUNTS DATE Jul 1 Interest expense Premium on bonds payable Cash 60 DEBIT CREDIT 1, 050 200 1, 250 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Adjusting Entries for Bonds Payable Interest payments seldom occur at year-end Interest must be accrued at year-end A payable account is credited for the liability Each interest entry must include amortization of discount or premium October, November, and December Actual interest payment date January, February, and March 61 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bonds Issued Between Interest Payment Dates Interest accrues from stated issue date Payments occur on stated interest payment dates Full payment to bondholders, regardless of their purchase date Payments cannot be split, full payments are made Interest accrued prior to issuance is collected at actual issue date Journal entry 62 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bonds Issued Between Interest Payment Dates Next interest payment date Interest payment recorded for normal six months Interest expense is equal to three months issued Interest payable decreased for the cash received at issue date Cash payment is always equal to the six month period 63 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Silk Realty issued $300, 000 of 8%, 10 -year bonds payable at par value on May 1, 2012, four months after the bond’s original issue date of January 1, 2012. 1. Journalize the issuance of the bonds payable on May 1, 2012. Journal Entry DATE May 1 Cash ACCOUNTS Bonds payable Interest payable 64 DEBIT CREDIT 308, 000 300, 000 8, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

(Continued) 2. Journalize the payment of the first semiannual interest amount on July 1, 2012. Journal Entry ACCOUNTS DATE May 1 Interest payable Interest expense Cash 65 DEBIT CREDIT 8, 000 4, 000 12, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

4 Report liabilities on the balance sheet 66 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Liabilities on the Balance Sheet Reports all current and long-term liabilities Payroll liabilities recorded * Amounts assumed Current portion of long -term liabilities Long-term liabilities 67 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Blue Socks’ account balances at June 30, 2014, include the following: Prepare the liabilities section of Blue Socks’ balance sheet at June 30, 2014. 68 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

69 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 11 Summary Bonds are a type of long-term debt usually sold by borrowing smaller amounts from more investors. Most bonds’ face or maturity value is $1, 000. The bonds will have a stated interest rate printed on the bond. This stated rate determines the amount of the interest payments. The market rate on the date a bond is issued may differ from the bond's stated rate. If it does, the bond will sell for a value other than its maturity or face value. If the market rate is greater than the stated rate, the bond will issue at a price below maturity value (discount). If the market rate is less than the stated rate, the bond will issue at a price above maturity value (premium). 70 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 11 Summary Regardless of whether bonds are issued at a price other than face value, the cash paid semiannually to bondholders is always the same amount because it is based on the interest rate stated on the face of the bond. When bonds are issued at a discount, the market interest rate is greater than the stated interest rate on the bonds, so interest expense is greater than the actual cash payments for interest. Whether bonds are issued at face value, discount, or premium, the bond maturity value is what the company must pay to the bondholders at the bond maturity date. Bond discount or premium is amortized using the straight-line method or the effective-interest method. 71 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 11 Summary Amortized discount increases interest expense. Amortized premium decreases interest expense. When bonds are issued between interest payment dates, interest is accrued. Current liabilities are those liabilities due in a year of the balance sheet date or the business operating cycle, whichever is longer. Long-term liabilities are those liabilities due over a year from the balance sheet date. Appendix 11 A: We began this appendix with straightline amortization to introduce the concept of amortizing bonds. A more precise way of amortizing bonds is used in practice, and it is called the effective-interest method. 72 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 11 Summary Generally accepted accounting principles require that interest expense be measured using the effectiveinterest method unless the straight-line amounts are similar. In that case, either method is permitted. Total interest expense over the life of the bonds is the same under both methods; however, interest expense each year is different between the two methods. 73 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 11 Summary The journal entry for the issuance of the bonds remains unchanged for the effective-interest amortization of bond discount or premiums. Interest expense is debited for market rate of interest times the carrying value of the bonds. Cash is credited for the stated rate of interest times the bonds maturity value. The difference between the interest expense and cash payment is the portion of the discount or premium on bonds being amortized for this period. 74 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 11 Summary Appendix 11 B : When retiring bonds before maturity, follow these steps: 1. Record partial-period amortization of discount or premium if the retirement date does not fall on an interest payment date. 2. Write off the portion of Discount or Premium that relates to the bonds being retired. 3. Credit a gain or debit a loss on retirement. 75 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

76 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 77 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.