Chapter 10 Accounting for Long-Term Debt This chapter explains accounting for interest and principal with respect to the major forms of long-term debt financing.

LO 10-1: Show how an installment note affects financial statements. Learning Objective 10-1: Show how an installment note affects financial statements.

Long-Term Notes Payable Long-term notes are liabilities that usually have terms from two to five years. Principal flows from the lender to a company; then payments flow from the company to the lender. 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. Part I Long-term notes are liabilities that usually have terms from two to five years. Part II The principal balance is repaid with a series of equal payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up with installment payments. Part III For each payment that is made, the amount applied to the principal increases and the amount of the interest decreases.

Long-Term Notes Payable (Continued) Applying payments to principal and interest Identify the unpaid principal balance. Amount applied to interest = Unpaid principal balance × Interest rate Amount applied to principal = Cash payment – Amount applied to interest in (2) Unpaid principal balance = Unpaid principal balance in (1) – Amount applied to principal in (3) To determine the portion of each payment that is interest and the portion to apply to the principal, follow these four steps: Identify the unpaid principal balance. (2) Multiply the unpaid principal balance times the interest rate to find the portion of the payment that is interest. (3) Subtract the portion of the payment that is interest in (2) from the total cash payment to find the portion of the payment to apply to the principal. (4) The updated unpaid principal balance equals the unpaid principal balance in (1) minus the portion of the payment applied to the principal in (3). Let’s look at an example.

Long-Term Notes Payable Example On January 1, Year 1, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9% annual interest rate and a five-year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year. Prepare an amortization table for Blair’s note. Take a minute and review this information for Blair Company. On January 1, Year 1, Blair Company borrowed $100,000 from National Bank. The loan has a 9% interest rate and will be repaid with five annual payments of $25,709 each. Let’s look at the amortization table for this loan.

Exhibit 10.1: Amortization for Installment Note Payable Accounting Period Column A Principal Balance on Jan. 1 Column B Cash Payment on Dec. 31 Column C Interest Expense Column D Principal Repayment Column E Principal Balance on Dec. 31 Column F Year 1 $100,000 $25,709 $9,000 $16,709 $83,291 Year 2 83,291 25,709 7,496 18,213 65,078 Year 3 5,857 19,852 45,226 Year 4 4,070 21,639 23,587 Year 5 25,710* 2,123 *All computations are rounded to the nearest dollar. To fully liquidate the liability, the final payment is one dollar more than the others because of rounding differences. Notice that the annual payment is always $25,709. Also notice that for each payment the interest portion decreases and the principal portion increases. Let’s review how to get the amount applied to interest and the amount applied to principal for the first payment on this note. The interest portion is calculated by multiplying the $100,000 unpaid balance at the beginning of the period times 9% to get $9,000. The principal portion is calculated by subtracting $9,000 from $25,709 to get $16,709. You should verify the remaining computations in the amortization table before advancing.

The Relationship of Principal to Interest Annual payments are constant. The amount applied to the principal increases each year. The amount of interest decreases each year. The graph on your screen shows that the amount of each payment applied to the principal increases each year, while the amount of interest decreases each year.

Long-Term Notes Payable Example (Continued) Issuing the note has the following effect on Blair’s Year 1 financial statements: The December Year 1 cash payment has the following effect on Blair’s Year 1 financial statements: Assets = Liab. + Stockholders' Equity   Revenue − Expenses Net Income Cash Flow   100,000 n/a FA Part I Issuing the note payable increases both assets (Cash) and liabilities (Notes Payable). There is no effect on the income statement when the note is issued. The cash inflow is reported in the financing activities section of the statement of cash flows. Part II Each payment decreases assets (Cash) by the amount of the payment. Liabilities (Notes Payable) decrease by the amount of the payment applied to principal. Equity (Retained Earnings) decreases by the amount of the payment that is interest. Net income decreases by the amount of interest. The portion of the payment that is interest is reported in the operating activities section of the statement of cash flows. The portion of the payment applied to principal is reported in the financing activities section of the statement of cash flows. Assets = Liab. + Stockholders' Equity   Revenue − Expenses Net Income Cash Flow   (25,709) (16,709) (9,000) n/a 9,000 OA FA

Exhibit 10.2: Impact on Financial Statements BLAIR COMPANY Financial Statements Income Statements   Year 1 Year 2 Year 3 Year 4 Year 5 Rent Revenue $12,000 Interest Expense (9,000) (7,496) (5,857) (4,070) (2,123) Net Income $ 3,000 $ 4,504 $ 6,143 $ 7,930 $ 9,877 Balance Sheets Assets Cash $86,291  $72,582 $58,873 $45,164 $31,454 Total Assets Liabilities Note Payable $83,291 $65,078 $45,226 $23,587 $ 0 Total Liabilities Stockholders' Equity Retained Earnings 3,000 7,504 13,647 21,577 31,454 Total Liabilities and Stockholders’ Equity $72,582 Statement of Cash Flow Cash Flows from Operating Activities Inflow from Customers Outflow for Interest Cash Flows from investing activities 0  Cash Flows from financing activities Inflow from issue of note 100,000 Outflow to repay note (16,709) (18,123) (19,852) (21,639) (23,587) Net change in Cash 86,291 (13,709) (13,709 (13,710) Plus Beginning Cash Balance 72,582 58,873 45,164 Ending Cash Balance Part I The illustration assumes that Blair earned $12,000 of rent revenue per year. Since some of the principal is repaid each year, the note payable amount reported in the balance sheet and the amount of interest expense on the income statement decline each year.

LO 10-2: Show how a line of credit affects financial statements. Learning Objective 10-2: Show how a line of credit affects financial statements.

Lines of Credit Enable the company to borrow and repay funds. Usually specify a maximum credit line. Normally used for short-term borrowing to finance seasonal business needs. Lines of credit are preapproved financing plans that allow companies to borrow and repay funds as needed up to the maximum credit line set by the creditor. Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs. For an individual, overdraft protection on a checking account is similar to a business line of credit.

LO 10-3: Describe bond features and show how bonds issued at face value affect financial statements. Learning Objective 10-3: Describe bond features and show how bonds issued at face value affect financial statements.

Bond Liability Features Long-term borrowing of a large sum of money, called the principal Principal is usually paid back as a lump sum at maturity. Individual bonds are often denominated with a face value of $1,000. When companies need large amounts of cash for longer periods of time, they often issue bonds. The principal on bonds is typically paid at the end of the bond period. Each bond in the total bond issue is usually denominated with a face value of $1,000.

Bond Liability Features (Continued) Periodic interest payments based on a stated rate of interest. Interest is paid semiannually. Interest paid is computed as: Interest = Principal × Stated Interest Rate × Time Bond prices are quoted as a percentage of the face amount. For example, a $1,000 bond priced at 104 would sell for $1,040. Bonds normally have an interest rate that is called a stated rate. Interest is normally paid semiannually and is computed as Principal times Rate times Time. This computation should look familiar to you. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their face value.

Bond Issue Date On the bond issue date, the bondholders give the company the market value, or selling price of the bond issue. In turn, the company gives the bondholders a bond certificate (at face value) promising to pay periodic interest and to return the principal on the maturity date. On the issue date, the bondholders give the company the market value, or selling price of the bond issue. The company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date.

After the Bond Issue Date At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as the bond face value times the stated interest rate (listed on the bond) times the amount of time that the bond has been outstanding during the year. At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as bond face value times the stated interest rate on the bond times the time the bond has been outstanding during the year.

On the Bond Maturity Date On the bond maturity date, the company pays the bondholder investors the bond’s face value. At the maturity date, the company pays the bondholders the bond’s face value.

Advantages of Bonds Longer term to maturity than notes payable issued to banks Bond interest rates are usually lower than bank loan rates Bonds offer advantages for the issuing company. They usually have longer terms to maturity than notes payable issued to banks, often 20 or 30 years. In addition, bond interest rates are usually lower than bank loan rates.

Characteristics of Bonds Term and Serial Secured and Unsecured Convertible and Callable There are several common types of bonds. Secured bonds, sometimes called mortgage bonds, have specific assets of the issuer pledged as collateral. Unsecured bonds, sometimes called debentures, are backed by the issuer’s general credit standing. Term bonds are scheduled for maturity on one specified date. Serial bonds mature at more than one date. Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.

Bond Issued at Face Value Example Mason Company issues bonds at face value to investors on January 1, Year 1. The investors pay the bond selling price equal to the principal of $100,000 to the company. The stated interest rate = 9% Interest is paid annually on December 31. Maturity date = December 31, Year 5 Mason Company issues bonds at face value. This means that the stated interest rate on the bond and the market interest rate on the bond are equal. Mason’s bonds have a face value of $100,000, and a stated interest rate of 9% with interest payable on December 31 of each year. The bonds are issued on January 1, Year 1, and mature five years later on December 31, Year 5. On the issue date, the bondholders give Mason Company the selling price of the bond issue, and Mason Company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date.

Bonds Issued at Face Value: Initial Recording Issuing the bonds has the following effect on Mason’s Year 1 financial statements: To record the bond issue, Mason makes the following entry on January 1, Year 1: Assets = Liab. + Stockholders' Equity   Revenue − Expenses Net Income Cash Flow   100,000 n/a FA Part I Issuing the bonds payable increases both assets (Cash) and liabilities (Bonds Payable). There is no effect on the income statement when the bonds are issued. The cash inflow is reported in the financing section of the statement of cash flows. Part II On the issue date, Mason Company would debit Cash and credit Bonds Payable for $100,000. The Bonds Payable account is always credited for the face value, or maturity value, of the bonds. Date   Account Title Debit Credit Year 1 Jan. 1 Cash 100,000 Bonds Payable

Bonds Issued at Face Value: Interest Payments On each interest payment date, Mason will pay $9,000 in interest to the investors. The amount is computed as follows: $100,000 × 9% = $9,000 On the each interest payment date for the five-year term of the bond issue, Mason will pay the bondholders a total of $9,000 in interest. The interest is calculated by multiplying $100,000 times 9%.

Recording the Interest Payments The December 31, Year 1 interest payment (and all other annual interest payments) has the following effect on Mason’s financial statements: To record an interest payment, Mason makes the following entry on each December 31: Assets = Liab. + Stockholders' Equity   Revenue − Expenses Net Income Cash Flow   (9,000) n/a 9,000 OA Part I Each interest payment decreases assets (Cash) and decreases equity (Retained Earnings) by the amount of the interest payment. Net income also decreases by the amount of the interest payment. The interest payment is reported in the operating activities section of the statement of cash flows. Part II On the interest payment date for the five-year term of the bond issue, Mason will debit Bond Interest Expense and credit Cash for $9,000. Date   Account Title Debit Credit Years (1-5) Dec. 31 Interest Expense 9,000 Cash

Bonds Issued at Face Value: Dec. 31, Year 5 On December 31, Year 5, Mason will return the $100,000 principal amount to the investors. The principal repayment on December 31, Year 5, will have the following effect on Mason’s Year 5 financial statements: To record the principal repayment, Mason Company would make the following entry on December 31, Year 5: Assets = Liab. + Stockholders' Equity   Revenue − Expenses Net Income Cash Flow   (100,000) n/a FA Part I On the maturity date, Mason Company will pay the bondholders $100,000, the face amount of the bonds. At this time, the debt is extinguished. Part II The repayment at maturity decreases assets (Cash) and decreases liabilities (Bonds Payable) by $100,000. Net income is not affected by the repayment. The repayment is reported in the financing section of the statement of cash flows. Part III On the maturity date, Mason Company will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for $100,000. Date   Account Title Debit Credit Year 5 Dec. 31 Bonds Payable 100,000 Cash

Exhibit 10.7: Impact on Financial Statements MASON COMPANY Financial Statements Income Statements   Year 1 Year 2 Year 3 Year 4 Year 5 Rent Revenue $12,000 Interest Expense (9,000) Net Income $ 3,000 $ 3,000 Balance Sheets Assets Cash $3,000  $6,000 $9,000 $15,000 Land 100,000 Total Assets $103,000  $106,000 $109,000 $112,000 Liabilities Bonds Payable $100,000 $ 0 Stockholders' Equity Retained Earnings 3,000 6,000 9,000 12,000 15,000 Total Liabilities and Stockholders’ Equity $106,000 Statement of Cash Flow Cash Flows from Operating Activities Inflow from Customers Outflow for Interest Cash Flows from investing activities 0  Outflow to Purchase Land (100,000) Inflow from sale of Land Cash Flows from financing activities Inflow from bond issue Outflow to repay bond liability Net change in Cash Plus Beginning Cash Balance Ending Cash Balance $6,000 Here are Mason Company’s financial statements with the impact of the face value bonds for a five-year period.

End of Chapter 10 End of Chapter 10. In this chapter, we learned about two types of long-term debt: notes payable and bonds payable. We examined issuing bonds at face value, at a discount, and at a premium.