1. 14 - 1 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Term Liabilities Chapter 14

2. 14 - 2 Bond Financing Bonds do not affect owner control. Interest on bonds is tax deductible. Bonds can increase return on equity. Advantages Bonds require payment of both periodic interest and par value at maturity. Bonds can decrease return on equity. Disadvantages A1

3. 14 - 3 Bond Trading A1 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.

4. 14 - 4 Bond Issuing Procedures A1

5. 14 - 5 Bond Certificate Bond Certificate Bond Selling Price Corporation Investors Bond Issuances P1 Transaction on the Bond Issue Date

6. 14 - 6 Bond Interest Payments Corporation Investors Bond Issue Date Bond Interest Payments Interest Payment = Bond Par Value × Stated Interest Rate x Time Bond Issuances Transactions during the bond life P1

7. 14 - 7 Bond Face Value Corporation Investors Bond Issuances Transaction on the Maturity Date P1

8. 14 - 8 Issuing Bonds at Par On Jan. 1, 2013, 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, 2032 (20 years) P1

9. 14 - 9 $800,000 × 9% × ½ year = $36,000 Issuing Bonds at Par On June 30, 2013, the issuer of the bond pays the first semiannual interest payment of $36,000. P1 This entry is made every six months until the bonds mature.

10. 14 - 10 Issuing Bonds at Par On December 31, 2032, the bonds mature and the issuer of the bond pays face value of $800,000 to the bondholders. P1

11. 14 - 11 Bond Discount or Premium P1

12. 14 - 12 Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: 96.454% of par value Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2013 Maturity Date: Dec. 31, 2015 (2 years) Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: 96.454% of par value Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2013 Maturity Date: Dec. 31, 2015 (2 years) Issuing Bonds at a Discount } } Bond will sell at a discount. P2

13. 14 - 13 On Dec. 31, 2013, Fila should record the bond issue. Issuing Bonds at a Discount Par value $ 100,000 Cash proceeds 96,454* Discount $ 3,546 *$100,000 x 96.454% Contra-Liability Account Contra-Liability Account P2

14. 14 - 14 Maturity Value Carrying Value Issuing Bonds at a Discount Amortizing a Bond Discount Using the straight-line method, the discount amortization will be $887 (rounded) every six months. $3,546 ÷ 4 periods = $887 (rounded) Amortizing a Bond Discount Using the straight-line method, the discount amortization will be $887 (rounded) every six months. $3,546 ÷ 4 periods = $887 (rounded) P2

15. 14 - 15 $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 8% × ½ = $4,000 $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 8% × ½ = $4,000 Fila will make the following entry every six months to record the cash interest payment and the amortization of the discount. Amortizing a Bond Discount P2

16. 14 - 16 Amortizing a Bond Discount P2 These two columns always sum to par value for a discount bond.

17. 14 - 17 Adidas issues bonds with the following provisions: Par Value: $100,000 Issue Price: 103.546% of par value Stated Interest Rate: 12% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2013 Maturity Date: Dec. 31, 2015 (2 years) Adidas issues bonds with the following provisions: Par Value: $100,000 Issue Price: 103.546% of par value Stated Interest Rate: 12% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2013 Maturity Date: Dec. 31, 2015 (2 years) Issuing Bonds at a Premium } } Bond will sell at a premium. P3

18. 14 - 18 Issuing Bonds at a Premium Par value $ 100,000 Cash proceeds 103,546* Premium $ 3,546 *$100,000 x 103.546% Adjunct-Liability Account Adjunct-Liability Account On Dec. 31, 2013, Adidas will record the bond issue as: P3

19. 14 - 19 Issuing Bonds at a Premium Maturity Value Carrying Value Amortizing a Bond Premium Using the straight-line method, the premium amortization will be $887 (rounded) every six months. $3,546 ÷ 4 periods = $887 (rounded) Amortizing a Bond Premium Using the straight-line method, the premium amortization will be $887 (rounded) every six months. $3,546 ÷ 4 periods = $887 (rounded) P3

20. 14 - 20 Amortizing a Bond Premium $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 12% × ½ = $6,000 $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 12% × ½ = $6,000 Adidas will make the following entry every six months to record the cash interest payment and the amortization of the discount. P3

21. 14 - 21 Amortizing a Bond Premium P3

22. 14 - 22 Bond Pricing P2 Cash Outflows related to Interest Payments Cash Outflows for par value at end of Bond life

23. 14 - 23 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, 2013 Maturity Date: Dec. 31, 2015 (2 years) 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, 2013 Maturity Date: Dec. 31, 2015 (2 years) P2 Present Value of a Discount Bond

24. 14 - 24 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) 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 P2

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28. 14 - 28 Bond Retirement 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. P4

29. 14 - 29 Bond Retirement 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, 2013, after the first interest payment. The bond carrying value is $104,500.The bonds have a call premium of $3,000. P4

30. 14 - 30 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. 15,000 shares × $2 par value per share P4

31. 14 - 31 Note Maturity Date Note Payable Cash CompanyLender Note Date When is the repayment of the principal and interest going to be made? Long-Term Notes Payable C1

32. 14 - 32 Note Maturity Date CompanyLender Note Date Single Payment of Principal plus Interest Long-Term Notes Payable C1 Single Payment of Principal plus Interest

33. 14 - 33 Note Maturity Date CompanyLender Note Date Regular Payments of Principal plus Interest Long-Term Notes Payable C1

34. 14 - 34 Installment Notes On January 1, 2013, 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. C1

35. 14 - 35 Installment Notes with Equal Payments C1

36. 14 - 36 Installment Notes with Equal Payments Let’s record the first payment made on December 31, 2013 by Foghog to the bank. Refer back to the amortization schedule to make the December 31, 2014 payment on the note. P5

37. 14 - 37 178. On January 1, Year 1 a company borrowed $70,000 cash by signing a 9% installment note that is to be repaid with 4 annual year-end payments of $21,607, the first of which is due on December 31, Year 1. (a) Prepare the company's journal entry to record the note's issuance. (b) Prepare the journal entries to record the first and second installment payments.

38. 14 - 38 a) Year 1 Jan. 1Cash70,000 Notes Payable 70,000 b) Year 1 Dec. 31Notes Payable15,307 Interest Expense ($70,000 * 0.09)6,300 Cash 21,607 Year 2 Dec. 31Notes Payable16,685 Interest Expense ($54,693 * 0.09)4,922 Cash 21,607

39. 14 - 39 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. C1

40. 14 - 40 An installment note is an obligation of the issuing company that requires a series of periodic payments to the lender Payments on an installment note normally include the accrued interest expense plus a portion of the amount borrowed.

41. 14 - 41 Payments on an installment note normally include the accrued interest expense plus a portion of the amount borrowed.

42. 14 - 42 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.

43. 14 - 43 Secured and Unsecured Term and Serial Registered and Bearer Convertible and Callable Features of Bonds and Notes A2

44. 14 - 44 131. Match each of the following terms with the appropriate definitions. (a) Bond (b) Callable bonds (c) Annuity (d) Contract rate (e) Sinking fund bonds (f) Secured bonds (g) Carrying value (h) Premium on bonds (i) Bond indenture (j) Debt-to-equity ratio

45. 14 - 45 __________ (1) Bonds that have specific assets of the issuer pledged as collateral. __________ (2) A series of equal payments at equal intervals. __________ (3) The difference between the par value of a bond and its higher issue price or carrying value. __________ (4) Bonds that give the issuer an option of retiring them at a stated amount prior to maturity. __________ (5) The interest rate specified in the bond indenture. __________ (6) The contract between the bond issuer and the bondholder(s); it identifies the rights and obligations of the parties.

46. 14 - 46 __________ (7) Bonds that require the issuer to create a fund of assets at specified amounts and dates to repay the bonds at maturity. __________ (8) The net amount at which bonds are reported on the balance sheet. __________ (9) The ratio of total liabilities to total stockholders’ equity. __________ (10) A written promise to pay an amount identified as the par value along with interest at a stated rate.

47. 14 - 47 Answer: 1. F; 2. C; 3. H; 4. B; 5. D; 6. I; 7. E; 8. G; 9. J; 10. A

48. 14 - 48 This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity. Debt-to-Equity Ratio Debt-to- Equity Ratio Total Liabilities Total Equity = A3

49. 14 - 49 Present Value of $1 Rate Periods3%4%5% 1 0.9709 0.9615 0.9524 2 0.9426 0.9246 0.9070 3 0.9151 0.8890 0.8638 4 0.8885 0.8548 0.8227 5 0.8626 0.8219 0.7835 6 0.8375 0.7903 0.7462 7 0.8131 0.7599 0.7107 8 0.7894 0.7307 0.6768 9 0.7664 0.7026 0.6446 10 0.7441 0.6756 0.6139 Appendix 14A: Present Values of Bonds and Notes 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 C2

50. 14 - 50 Present Value of Annuity of $1 Rate Periods3%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 8.1109 7.7217 Appendix 14A: Present Values of Bonds and Notes $100,000 × 8% × ½ = $4,000 Semiannual Interest Annuity Present AmountPV FactorValue Principal $ 100,000 0.8227 $ 82,270 Interest 4,000 3.5460 14,184 Issue price of debt $ 96,454 $4,000 × 3.5460 = $14,184 C2

51. 14 - 51 Appendix 14B: Effective Interest Amortization $96,454 × 5% = $4,823 $100,000 - $2,723 = $97,277 P6 Effective Interest Amortization of Bond Discount Stated Rate: 8% Effective Rate: 10%

52. 14 - 52 Appendix 14B: Effective Interest Amortization $103,546 × 5% = $5,177 $100,000 + $2,723 = $102,723 P7 Effective Interest Amortization of Bond Premium Stated Rate: 12% Effective Rate: 10%

53. 14 - 53 Appendix14C: Issuing Bonds Between Interest Dates Avia sells $100,000 of its 9% bonds at par on March 1, 2013, 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 First Interest date 6/30 $1,500 accrued $3,000 earned Bondholder pays $1,500 to issuer Issuer pays $4,500 to bondholder C3

54. 14 - 54 Appendix 14D: 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. C4

55. 14 - 55 Appendix 14D: 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. C4

56. 14 - 56 End of Chapter 14