Long-Term Liabilities Chapter 14

Long-Term Debit: General Long-term debt consists of probable future sacrifices. It has various covenants or restrictions for the protection of both lenders and borrowers. The indenture agreement incorporates the terms of the issue and restrictions.

Issuing Bonds Bonds are the most common type of long-term debt. A bond indenture is a promise (by the lender to the borrower) to pay: a sum of money at the designated date, and periodic interest at a stipulated rate on the face value.

Bond Issues: Parties to the Contract lend cash Issuer of Bonds Bondholders 3. Payment of Face Value (maturity) 2. Payment Periodic Interest 1. Bond Certificate

Types of bonds: Secured and unsecured bonds Term, Serial, and Callable bonds Convertible, Commodity-Backed, and Deep discount bonds Commodity-backed bonds Registered and bearer (coupon) bonds Income and Revenue bonds

Valuation of Bonds payable Discount and premium The price of a bond issue is determined by: the present value of the interest payments, and the present value of the face value, both discounted at the market (effective) rate of interest at date of issue. Interest payments by borrower are calculated as: Face value of bond issue x Stated (face) rate of interest.

Valuation of Bonds payable Discount and premium The interest rate written in the terms of bond indenture is known as the stated, coupon, or nominal rate. - stated rate is the rate used to determine the amount of cash interest the borrower pays and the investor receives.( usually stated as annual rate). The face value is the amount of principal the issuer must pay at the maturity date. The present value of bonds is the value at which it should sell in the marketplace.

If the bonds sell for if the bonds sell for Under which conditions of bonds issuance does a discount on bonds payable arise? Under which conditions of bonds issuance does a premium on bonds payable arise? The difference between the face value and the present value of the bonds is either: Discount or Premium If the bonds sell for if the bonds sell for less than face value more than face value

Present value of the principle: $100,000 × .59345 (table 6-2) $59,345 Example: ServiceMaster issues $100,000 in bonds, due in 5 years with 9 percent interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11 percent. (The market rate is the rate investors demand for loaning funds) Present value of the principle: $100,000 × .59345 (table 6-2) $59,345 Present value of the interest payment: $9,000 × 3.69590 (table6-4) $33,263,10 Present value (selling price) of the bonds $92,608,10

Year 1 Year 2 Year 3 Year 4 Year 5 $9,000 Interest $100,000 face value Redemption at maturity ==> Interest = $100,000 x 9% per year stated rate

Bond issued at par on interest date When bonds are issued on an interest payment date at face value, no interest has occurred and no premium or discount exists. Example: If 10-yearterm bonds with a par value of $800,000 dated in Jan1, 2004, and bearing interest at an annual rate of 10 percent payable semi-annually on Jan1 and July 1, are issued on Jan 1 at par.

The entry on the books of the issuing corporation would be: Cash 800,000 Bonds Payable 800,000 The entry to record the first semi-annual interest payment of 40,000 (800,000 × 10% × ½)on July 1, 2004, would be: Bond interest expense 40,000 Cash 40,000 The entry to record accrued expense at Dec 31, 2004 (year-end) would be: Bond interest payable 40,000

Bonds issued at discount or Premium on interest date 1- Discount ( a discount is amortized either by the straight line method or the effective interest method.) From the previous example, assume that $800,000 of bonds were issued on Jan 1, 2004 at 97% of par, he issuance would be recorded as follows: Cash (800,000 × .97) 776,000 Discount on bonds payable 24,000 Bonds payable 800,000

The discount is amortized and charged to interest expense over the period of time that the bonds are outstanding. Under the straight-line method, the amount amortized each year is a constant amount. The discount is 24,000, so the amount amortized to interest expense each year is 2,400 (24,000 / 10 years) Total Discount or Premium Total Number of Periods The amortization is recorded as follows: Bonds interest expense 2,400 Discount on bonds payable 2,400

At the end of the first year: The unamortized balance in discount on bonds payable is: 24,000 – 2,400 = 21,600 (The balance of the discount is subtracted from the bonds payable in he balance sheet) Assume that the bonds were sold in Oct 2004, so there are three months of accrued interest must be recorded on Dec 31.

2- Premium ( a premium is amortized either by the straight line method or the effective interest method.) From the previous example, assume that the bonds are sold in Jan1, 2004 at 103%, so the entry will be: Cash (800,000 × 1.3) 824,000 Premium on bonds payable 24,000 Bonds payable 800,000 At the end of the year, the entry to amortized the premium will be Premium on bonds payable 2,400 Bond interest expense 2,400 Bond interest is increased by amortization of discount and decreased by amortization of premium. Any premium or discount must be amortized over the life to maturity date because early redemption (call of bond) is not a certainty.

Bonds Issued Between Interest Dates When the bonds are issued on other than the interest payment dates, buyers of the bonds will pay the seller the interest accrued from the last interest payment date on the date of issue. The purchasers will receive the full 6-months’ interest payment n the next semiannual interest payment date. Example: If 10-year bonds of a par value of $800,000, dated Jan 1, 2004, and bearing interest at an annual rate of 10 percent payable semiannually on Jan 1 and July 1, are issued on March 1, 2004 at par plus accrued interest.

The entry on the books of the issuing corporation is: Cash 813,333 Bonds Payable 800,000 Bond interest expense (800,000 × .10 × 2/12 ) 13,333 On July 1, 2004, the company will make the following entry: Bond interest expense 40,000 Cash 40,000 The interest expense account will have a debit balance of $26,667 which represent the proper amount of interest expense (800,000 × .10 × 4/12)

Bonds payable 800,000 Premium on bonds payable (800,000× 2%) 16,000 Example: From the previous example, assume that the 10% bonds were issued at 102. the entry on March 1 will be as follows: Cash (800,000 × 1.02) + (800,000 × .10× 2/12) 829,333 Bonds payable 800,000 Premium on bonds payable (800,000× 2%) 16,000 Bond interest expense 13,333 The premium would be amortized from the date of sale, which is March1,2004, not the date from of the bonds, which is Jan1, 2004

Effective Interest Method The effective interest method is also called the present value amortization which is the preferred procedure for amortization of discount or premium. 1- Bond interest expense is computed first by multiplying the carrying value( which is book value) of the bonds at the beginning of the period by the effective interest rate. 2- The bond discount or premium amortization is then determined by comparing the bond interest expense with the interest to be paid.

- = Bond interest expense Bonds interest paid Carrying value - = Amortization amount Bonds interest paid Face amount × Stated of bonds interest rate Bond interest expense Carrying value Of bonds × effective interest Beginning rate of period

Bonds Issued at Discount Example: Evermaster Corporation issued $100,000 of 8% term bonds on Jan 1,2004, due on Jan 1,2009, with interest payable each July 1 and Jan 1 . Because the investors required an effective interest rate of 10%, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. The $7,722 discount is computed as follows: Maturity value of bonds payable 100,000 Present value of 100,000 due in 5 years at 10%, interest payable Semiannually (100,000 × .61391) 61,391 Present value of 4,000 interest payable semi-annually for 5 years At 10% annually (4,000 × 7.72173) 30,887 Proceeds from sale of bonds 92,278 Discount on bonds payable 7,722

Schedule of bond discount amortization Date Cash paid Interest Discount Carrying amount Expense amortized of bonds 1/1/04 92,278 7/1/04 4,000 a 4,614b 614c 92,892d 1/1/05 4,000 4,645 645 93,537 7/1/05 4,000 4,677 677 94,214 1/1/06 4,000 4,711 711 94,925 7/1/06 4,000 4,746 746 95,671 1/1/07 4,000 4,783 783 96,454 7/1/07 4,000 4,823 823 97,277 1/1/08 4,000 4,864 864 98,141 7/1/08 4,000 4,907 907 99,048 1/1/09 4,000 4,952 952 100,000 40,000 47,722 7,722 A: 4,000 = 100,000 × 8% × 6/12 B: 4,614 = 92,278 × 10% × 6/12 C: 614 = 4,614 – 4,000 D: 92,892 = 92,278 + 614

The entry to record the issuance of the bonds at discount on Jan 1, 2004 is: Cash 92,278 Discount on Bonds payable 7,722 Bonds Payable 100,000 The entry to record the first interest payment in July 1,2004 and amortization of the discount is: Bond Interest Expense 4,614 Discount on Bonds Payable 614 Cash 4,000 The entry to record the interest expense accrued at Dec 31,2004 and amortization of the discount is: Bond Interest Expense 4,645 Bond Interest Payable 4,000 Discount on Bonds Payable 645

Bonds Issued at Premium Example From the previous example, assume that the investors were willing to accept an effective interest rate of 6% on the bond issue, and they would have paid $108,530 or premium of $8,530. Maturity value of bonds payable 100,000 Present value of 100,000 due in 5 years at 6%, interest payable Semi-annually (100,000 × .74409) 74,409 Present value of 4,000 interest payable semi-annually for 5 years At 6% annually (4,000 × 8.53020) 34,121 Proceeds from sale of bonds 108,530 Premium on bonds payable 8,530

Schedule of bond premium amortization Date Cash paid Interest Premium Carrying amount Expense amortized of bonds 1/1/04 108,530 7/1/04 4,000 a 3,256b 744c 107,786d 1/1/05 4,000 3,234 766 107,020 7/1/05 4,000 3,211 789 106,231 1/1/06 4,000 3,187 813 105,418 7/1/06 4,000 3,162 838 104,580 1/1/07 4,000 3,137 863 103,717 7/1/07 4,000 3,112 888 102,829 1/1/08 4,000 3,085 915 101,914 7/1/08 4,000 3,057 943 100,971 1/1/09 4,000 3,029 971 100,000 40,000 31,471 8,530 A: 4,000 = 100,000 × 8% × 6/12 B: 3,256 = 108,530 × 6% × 6/12 C: 744 = 4,000 – 3,256 D: 107,786 = 108,530 - 744

The entry to record the issuance of bonds at premium on Jan 1, 2004, is: Cash 108,530 Premium on bonds Payable 8,530 Bonds Payable 100,000 The entry to record the first interest payment on July 1,2004 and amortization of the premium is: Bond interest expense 3,256 Premium on bonds payable 744 Cash 4,000

Accruing Interest In the previous examples, the two interest payment dates coincided with the financial reporting dates. However, if the financial statements are reported at the end of Feb, the premium or discount will be reported by the appropriate number of months to get the proper interest expense.

Interest accrual (4,000 × 2/6) 1,333.33 Premium amortized (744 × 2/6) 284 Interest expense 1,085.33 The entry to record this accrual is: Bond Interest Expense 1,085.33 Premium on Bonds Payable 248 Bond Interest Payable 1,333.33

Long-Term Notes Payable The difference between current notes payable and long-term notes payable. Note issued at face value Cash 10,000 Notes Payable 10,000 Notes not issued at face value Zero-Interest-Bearing Notes Interest-Bearing Notes

Exercises On Dec 2004, Gulf Software issued $1.0 million, 10%, 10 year bonds at face value. Interest is payable semiannually on Jan 1 and July1 A- Journalize the issuance of the bonds on Jan , 2005. B- Prepare the journal entries for interest expense in 2005.

(to record issuance of bonds) B- July 1 Bond Interest Expense 50,000 A- Jan 1 Cash 1,000,000 Bonds Payable 1,000,000 (to record issuance of bonds) B- July 1 Bond Interest Expense 50,000 Cash 50,000 (to record payment of semiannual interest, 1000,000 × 10%× 6/12) Dec 31 Bond Interest Payable 50,000 ( to record accrual of semi-annual interest)

BE14-2 The Goofy company issued $200,000 of 10% bonds on Jan 1, 2005. The bonds are due Jan 1, 2010, with interest payable each July 1 and Jan 1. The bonds are issued at face value. Prepare Goofy’s journal entries for (a) the Jan issuance, (b) the July 1 interest payment, and (c) the Dec 31 adjustment entry. A- Jan 1 Cash 200,000 Bonds Payable 200,000 (to record issuance of bonds) B- July 1 Bond Interest Expense 10,000 Cash 10,000 (to record payment of semiannual interest, 200,000 × 10%× 6/12) C- Dec 31 Bond Interest Payable 10,000 ( to record accrual of semi-annual interest)

BE14-3 Assume the bonds in BE14-2 were issued at 98%. Prepare the journal entries for (a) the Jan issuance, (b) the July 1 and (c) the Dec 31 adjustment entry. Assume the Goofy company records straight-line amortization annually on Dec 31. A- Cash (200,000 × .98) 196,000 Discount on bonds payable 4,000 Bonds payable 200,000 B- The discount is 4,000, so the amount amortized to interest expense each year is 800 ( 4,000 / 5 years) because it’s semi-annually, it will be $400 July entry is: Bond interest expense 10,000 Discount on bonds payable 400 Cash 9,600 C- Dec 31 Bonds interest expense 10,000 Bond interest payable 9,600 The July and Dec entries will be the same in all five years

Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather, it is a contra account. This account is deducted from bonds payable on the balance sheet. Goofy Company Balance Sheet Long-term Liabilities Bonds Payable 200,000 Less: Discount on bonds Payable 3,200 Note: the balance of the discount is deducted from the bonds payable, so at the end of the year the balance of the discount will be 3,200. so this amount will be subtracted from the bonds payable in the balance sheet.

Discount on Bonds Payable Jan1, 2005 4,000 July 1, 2005 400 Dec 31, 2005 400 Bal. Jan 1. 2006 3,200 July 1, 2006 400 Dec 31, 2006 400 Bal. Jan 1. 2007 2,400 July 1, 2007 400 Dec 31, 2007 400 Bal. Jan 1. 2008 1,600 July 1, 2008 400 Dec 31, 2008 400 Bal. Jan 1. 2009 800 July 1, 2009 400 Dec 31, 2009 400

Balance Sheet At Dec 31, 2005 Long-term Liabilities 200,000 Less: Discount on bonds Payable 3,200 196,800 Balance Sheet At Dec 31, 2006 Long-term Liabilities 200,000 Less: Discount on bonds Payable 2,400 197,600 Balance Sheet At Dec 31, 2007 Long-term Liabilities 200,000 Less: Discount on bonds Payable 1,600 198,400 Balance Sheet At Dec 31, 2008 Long-term Liabilities 200,000 Less: Discount on bonds Payable 800 198,200 Balance Sheet At Dec 31, 2009 Long-term Liabilities 200,000 Note: If there is redemption of the bonds in 2009, the account will be closed by making bonds payable debit and cash credit.

BE14-4 Assume the bonds in BE14-2 were issued at 103%. Prepare the journal entries for (a) the Jan issuance, (b) the July 1 and (c) the Dec 31 adjustment entry. Assume the Goofy company records straight-line amortization annually on Dec 31. A- Cash (200,000 × 103%) 206,000 Premium on bonds payable 6,000 Bonds payable 200,000 B- July entry is: Bond interest expense 9,400 Premium on bonds payable 600 Cash 10,000 C- Dec 31 Bonds interest expense 9,400 Premium on bonds payable 600 Bond interest payable 10,000

Premium on bonds payable is added to bonds payable on the balance sheet. Goofy Company Balance Sheet Long-term Liabilities Bonds Payable 200,000 Add: Premium on bonds Payable 4,800 Note: the balance of the premium is added to the bonds payable, so at the end of the year the balance of the premium will be 4,800. so this amount will be added on the bonds payable in the balance sheet.

Balance Sheet At Dec 31, 2005 Long-term Liabilities 200,000 Add: Premium on bonds Payable 4,800 204,800 Balance Sheet At Dec 31, 2006 Long-term Liabilities 200,000 Add: Premium on bonds Payable 3,600 203,600 Balance Sheet At Dec 31, 2007 Long-term Liabilities 200,000 Add: Premium on bonds Payable 2,400 202,400 Balance Sheet At Dec 31, 2008 Long-term Liabilities 200,000 Add: Premium on bonds Payable 1,200 201,200 Note: If there is redemption of the bonds in 2009, the account will be closed by making bonds payable debit and cash credit. Balance Sheet At Dec 31, 2009 Long-term Liabilities 200,000

Premium on Bonds Payable July 1, 2005 600 Dec 31, 2005 600 Jan1, 2005 6,000 July 1, 2006 600 Dec 31, 2006 600 Bal. Jan 1. 2006 4,800 July 1, 2007 600 Dec 31, 2007 600 Bal. Jan 1. 2007 3,600 July 1, 2008 600 Dec 31, 2008 600 Bal. Jan 1. 2008 2,400 July 1, 2009 600 Dec 31, 2009 600 Bal. Jan 1. 2009 1,200

Exercise: Garden, Inc issued $100,000 of 10%, 5-year bonds on Jan 1, 2001, with interest payable each July 1 and Jan 1. Bonds were sold for $92,639, and an effective-interest rate of 12%. (a) prepare bond discount amortization schedule. (b) journal entries for Jan issuance and July 1 interest payment and Dec 31 adjusting entry. Maturity value of bonds payable 100,000 Present value of 100,000 due in 5 years at 12%, interest payable Semi-annually (100,000 × .55839) 55,839 Present value of 5,000 interest payable semi-annually for 5 years At 12% annually (5,000 × 7.36009) 36,800 Proceeds from sale of bonds 92,239 Discount on bonds payable 7,361

Schedule of bond discount amortization Date Cash paid Interest Discount Carrying amount Expense amortized of bonds 1/1/01 92,639 7/1/01 5,000 a 5,558b 558c 93,197d 1/1/02 5,000 5,592 592 93,789 7/1/02 5,000 5,627 627 94,416 1/1/03 5,000 5,665 665 95,081 7/1/03 5,000 5,705 705 95,786 1/1/04 5,000 5,747 747 96,533 7/1/04 5,000 5,792 792 97,325 1/1/05 5,000 5,840 840 98,165 7/1/05 5,000 5,890 890 99,055 1/1/06 5,000 5,945 945 100,000 50,000 57,361 7,361 A: 5,000 = 100,000 × 10% × 6/12 B: 5,558 = 92,639 × 12% × 6/12 C: 558 = 5,558 – 5,000 D: 93,197 = 92,639 + 558

Discount on Bonds Payable 592 Jan 1, 2001 Cash (200,000 × .98) 92,639 Discount on bonds payable 7,361 Bonds payable 100,000 July 1, 2001 Bond Interest Expense 5,585 Discount on Bonds Payable 558 Cash 5,000 Dec 31, 2001 Bond Interest Expense 5,592 Bond Interest Payable 5,000 Discount on Bonds Payable 592

Homework Ortiz, Inc issues $100,000 of 10%, 5-year bonds on Jan 1, 2004, with interest payable each July 1 and Jan 1. The bonds sell for $108,111, and an effective-interest rate of 8%. (a) prepare bond premium amortization schedule. (b) journal entries for Jan issuance and July 1 interest payment and Dec 31 adjusting entry.