1 Chapter 10 Long-Term Liabilities Bonds Payable and other long-term debt are issued by a company to generate cash flow. Bonds Payable represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. The present value of the cash flows is the amount at which the bonds will issue.

2 Bonds Payable Issued for financing purposes. Advantages compared to issuing equity (ex: common stock) – do not affect ownership control. – interest on bonds is tax deductible (dividends are not deductible). Disadvantages compared to issuing equity – Increases debt to equity ratio. – interest payments are required to prevent default (where dividends are not required).

3 Journal Entries for Bonds Payable Bonds may be issued at face value, or at an amount greater than face value (premium), or an amount less than face value (discount). The amount of the stated interest rate offered by the company affects the price of the bond issue: – Higher than market rate: issue at a premium – Lower than market rate: issue at a discount Premium on B/P: (adjunct account) adds to bonds payable (normal credit balance) Discount on B/P: (contra account) reduces bonds payable (normal debit balance Carrying value of bonds = Face value + premium or Face value - discount

4 Bonds Payable at a Discount. If bonds are issued at a discount, the carrying value will be below face value at the date of issue. The Discount on B/P account has a normal debit balance and is a contra to B/P. The Discount account is amortized with a credit. Note that interest expense now equals the sum of the Cash Paid and the amount of the amortization. Int. expense = cash paid + discount amort. The company incurs additional interest expense because the discount is a cost to the company (must still pay back face value).

5 Illustration 1: Bonds Payable (Discount) On January 1, 2006, Corvette Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 5%, and pay interest annually each December 31, starting December 31, The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = (2) Stated Interest = Face value x stated rate x time period Number of periods = n = 5 yrs Discount rate = 6% per year

6 Illustration 1 : Present Value Calculations PV of interest annuity: PVA Table PVA Table PVA = A( ) = i, n i = 6%, n=5 PV of face value: PV1 Table PV1 Table PV =FV1( ) = i, n I = 6%, n=5 Total issue price = Issued at a discount of $4,212 because the company was offering an interest rate less than the market rate, and investors were not willing to pay as much for the lower interest rate.

7 Illustration 1 : Journal Entry at Issue JE at 1/1/06 to issue the bonds: Discount on Bonds Payable is located in the liability section of the balance sheet, as a contra, and offsets Bonds Payable. On the balance sheet at 1/1/06: Liabilities Bonds Payable Discount on B/P (the carrying value is 95,788)

8 Illustration 1 : Journal Entry to Pay Interest JE at 12/31/06 to pay interest: Calculations first: Cash paid=Face x stated rate x time = = 100,000 x.05 x 1 yr. = $5,000 Interest expense = CV x market rate x time = = 95,788 x.06 x 1 yr = $5,747 (rounded) Amortization of discount = difference (plug) = 5,747 – 5,000 = 747 (credit) Now journal entry:

9 Illustration 1 - Amortization Schedule Cash Interest Carrying Date Paid Expense Difference Value 1/01/06 95,788 12/31/06 5,000 5, ,535 12/31/07 5,000 5, ,327 12/31/08 5,000 5, ,167 12/31/09 5,000 5, ,057 12/31/10 5,000 5, ,000 Cash paid = Face Value x Stated Rate x Time Int. expense = Carrying Value x Mkt. Rate x Time

10 Illustration 2: Premium On July 1, 2005, Camero Corporation issues $50,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = $100,000 (2) Stated Interest = Face value x stated rate x time period 100,000 x.07 x 1/2 = $3,500 Number of periods = n = 5 yrs x 2 = 10 Discount rate = 6% / 2 = 3% per period

11 Illustration 2 - Solution PV of interest annuity: PVA Table PVA Table PVA = A( ) = 3,500 (8.530) = $29,855 i, n i = 3%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.744)=$74,400 i, n i=3%, n=10 Total issue price = $104,255 Issued at a premium of $4,255 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

12 Illustration 2 - Amortization Schedule Cash Interest Carrying Date Paid Expense Difference Value 7/01/05 104,255 12/31/05 3,500 3, ,883 6/30/06 3,500 3, ,500 12/31/06 3,500 3, ,105 6/30/07 3,500 3, ,698 12/31/07 3,500 3, ,279 6/30/08 3,500 3, ,848 12/31/08 3,500 3, ,404 6/30/09 3,500 3, ,946 12/31/09 3,500 3, ,475 6/30/10 3,500 3, *100,000 *rounding difference

13 Illustration 2 - Journal Entries JE at 12/31/05 to pay interest: Note that the numbers for interest change each period because the carrying value changes, but the cash payment is the same each period. JE at 6/30/2010 to retire the bonds:

14 Retirement of Bonds Bonds are retired when the company pays the investors the amount owed. If bonds are held to maturity, the amount on the books is face value and the amount paid is face value. If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized.

15 Retirement of Bonds The gain or loss is the difference between carrying value and cash paid. – If cash paid is greater than CV, recognize loss (paid more than book liability). – If cash paid is less than CV, recognize gain (paid less than book liability). When recording the early retirement, we must remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount). The gain or loss is recognized as part of Income from Continuing Operations (Other Revenues and Gains or Other Expenses and Losses).

16 Back to Illustration 2 – Bond Retirement Assume that Camaro’s bonds were retired on June 30, 2006 (after the interest payment). Camaro Corporation paid $103,000 to retire the bonds from the marketplace. Record the entries on June 30, JE at 6/30/06 to pay the interest (see Slide 12): JE at 6/30/06 to retire the bonds (CV = 103,500; see Slide 12):