©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Long-Term Liabilities Chapter 15

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Bonds: An Introduction l A bond is an interest bearing long-term note payable. l Bonds are groups of notes payable issued to multiple lenders called bondholders. – principal – interest rate – interest payment dates

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Types of Bonds Term bonds Serial bonds Secured or mortgage bonds Secured or mortgage bonds Debenture bonds

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Bond Prices l A bond is quoted as a percent of its face value. l A quote of 99½ means that a $1,000 bond sells for $1,000 × 0.995, or $995. l Bond prices are affected by... – time to maturity. – credit rating of issuer. – interest rate.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Present Value l The amount invested today receives a greater amount at a future date which is called the present value of a future amount. l It depends upon... – the amount of the future receipt. – the length of time to the future receipt. – interest rate for the period.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Issuing Bonds Payable to Borrow Money l On January 1, Granite Corp. issued $1,000,000 of 10%, 10-year bonds. January 1 Cash1,000,000 Bonds Payable1,000,000 To issue 10%, 10-year bonds January 1 Cash1,000,000 Bonds Payable1,000,000 To issue 10%, 10-year bonds

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Issuing Bonds Payable to Borrow Money l What is the entry for the interest payment of July 1? l $1,000,000 × 10% × 1/2 = $50,000 July 1 Interest Expense50,000 Cash50,000 To record semiannual interest July 1 Interest Expense50,000 Cash50,000 To record semiannual interest

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Issuing Bonds and Notes Payable Between Interest Dates l On March 31, Granite Corp. sells $1,0000,000 of 10%, 10-year bonds dated January 1. March 31 Cash1,025,000 Bonds Payable1,000,000 Interest Payable 25,000 To issue 10%, 10-year bonds at par three months after original issue date March 31 Cash1,025,000 Bonds Payable1,000,000 Interest Payable 25,000 To issue 10%, 10-year bonds at par three months after original issue date

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Issuing Bonds and Notes Payable Between Interest Dates l What is the July 1 interest expense? l $1,000,000 × 10% × 1/4 = $25,000 June 30 Interest Expense25,000 Interest Payable25,000 Cash50,000 To pay semiannual interest June 30 Interest Expense25,000 Interest Payable25,000 Cash50,000 To pay semiannual interest

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber A 10-year, $1,000,000 bond issue is sold by Granite Corp. at 99¼ on January 1. The contract rate of interest is 10% (20 periods). A 10-year, $1,000,000 bond issue is sold by Granite Corp. at 99¼ on January 1. The contract rate of interest is 10% (20 periods). Cash992,500 Discount on Bonds Payable 7,500 Bonds Payable1,000,000 To issue 10%, 10-year bonds at a discount Cash992,500 Discount on Bonds Payable 7,500 Bonds Payable1,000,000 To issue 10%, 10-year bonds at a discount Issuing Bonds Payable at a Discount

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Account for basic bonds payable transactions by the straight-line amortization method. Objective 1

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Straight-Line Amortization of Bond Discount l This method amortizes the bond discount by dividing it into equal amounts for each interest period. l Granite Corp. would amortize the $7,500 discount over 20 periods. l $7,500 ÷ 20 = $375 per period

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber July 1 Interest Expense50,375 Cash50,000 Discount on Bonds Payable 375 Paid semiannual interest and amortized discount on bonds payable July 1 Interest Expense50,375 Cash50,000 Discount on Bonds Payable 375 Paid semiannual interest and amortized discount on bonds payable Straight-Line Amortization of Bond Discount

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Granite Corp. sold a 10%, 10-year (20 periods), $1,000,000 bond issue at a price of 101 on Jan. 1. Granite Corp. sold a 10%, 10-year (20 periods), $1,000,000 bond issue at a price of 101 on Jan. 1. Cash1,010,000 Bonds Payable1,000,000 Premium on Bonds Payable 10,000 Issued bonds payable at a premium Cash1,010,000 Bonds Payable1,000,000 Premium on Bonds Payable 10,000 Issued bonds payable at a premium Issuing Bonds Payable at a Premium

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Issuing Bonds Payable at a Premium Granite Balance Sheet (immediately after issuance of the bonds) Granite Balance Sheet (immediately after issuance of the bonds) Long-term liabilities: Bonds payable, 10%, due 20xx$1,000,000 Premium of bonds payable 10,000 $1,010,000 Long-term liabilities: Bonds payable, 10%, due 20xx$1,000,000 Premium of bonds payable 10,000 $1,010,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber July 1 Interest Expense40,500 Premium on Bonds Payable 500 Cash50,000 Paid semiannual interest and amortized premium on bonds payable July 1 Interest Expense40,500 Premium on Bonds Payable 500 Cash50,000 Paid semiannual interest and amortized premium on bonds payable Straight-Line Amortization of Bond Premium

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Granite Balance Sheet (December 31) Long-term liabilities: Bonds payable, 10%, due 20xx$1,000,000 Premium on bonds payable 9,000 $1,009,000 Long-term liabilities: Bonds payable, 10%, due 20xx$1,000,000 Premium on bonds payable 9,000 $1,009,000 Reporting Bonds Payable

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Adjusting Entries for Interest Expense l San Antonio Corporation issued $150,000 of its 8%, 10-year bonds at a $3,000 discount on October 1, l The interest payments occur on March 31 and September 30 each year. l San Antonio closes its books on December 31. l What accounts are involved?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Adjusting Entries for Interest Expense l Interest Payable: $150,000 × 8% × 3/12 = $3,000 l Discount Amortization: $3,000 ÷ 10 × 3/12 = $75 l Interest Expense: $3,000 + $75 = $3,075 l What is the adjusting entry?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Adjusting Entries for Interest Expense December 31, 2002 Interest Expense3,075 Interest Payable3,000 Discount on Bonds Payable 75 Accrued three months’ interest and amortized discount on bonds payable December 31, 2002 Interest Expense3,075 Interest Payable3,000 Discount on Bonds Payable 75 Accrued three months’ interest and amortized discount on bonds payable What is the entry on March 31, 2003?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Adjusting Entries for Interest Expense March 31, 2003 Interest Expense3,075 Interest Payable3,000 Cash6,000 Discount on Bonds Payable 75 Paid semiannual interest, part of which was accrued, and amortized three months’ discount on bonds payable March 31, 2003 Interest Expense3,075 Interest Payable3,000 Cash6,000 Discount on Bonds Payable 75 Paid semiannual interest, part of which was accrued, and amortized three months’ discount on bonds payable

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measure interest expense by the effective-interest method. Objective 2

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method of Amortization l The effective-interest method keeps interest expense at the same percentage over any bond’s life. l Generally accepted accounting principles require that interest expense be measured using the effective-interest method.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method: Bond Discount l Assume that Granite Corp. issues $100,000 of its 9% bonds at a discount of $3,851, at a time when the market rate of interest is 10%. l These bonds mature in five years and pay interest semiannually.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method: Bond Discount Cash96,149 Discount on Bonds Payable 3,851 Bonds Payable100,000 To issue 10%, 10-year bonds at a discount Cash96,149 Discount on Bonds Payable 3,851 Bonds Payable100,000 To issue 10%, 10-year bonds at a discount

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method: Bond Discount l What is the interest expense at the end of period one? l $96,149 × 10% × 6/12 = $4,807 l What is the interest payment at the end of period one? l $100,000 × 9% × 6/12 = $4,500 l $4,807 – $4,500 = $307 amortization

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method: Bond Discount End ofCarrying InterestCash Period ValueExpensePaid Amortization Issue 96,149 Date 1 96,456 4,8074, ,779 4,8234, ,118 4,8394, ,474 4,8564, End ofCarrying InterestCash Period ValueExpensePaid Amortization Issue 96,149 Date 1 96,456 4,8074, ,779 4,8234, ,118 4,8394, ,474 4,8564,500356

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method: Bond Premium l Assume the Granite Corp. issues a $100,000, 5-year, 9% bond to yield 8%, at a premium of $4,100. l The first period interest expense is computed as follows: l $104,100 × 8% × 6/12 = $4,164

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Effective-Interest Method: Bond Discount End ofCarrying InterestCash Period ValueExpensePaid Amortization Issue104,100 Date 1103,764 4,1644, ,415 4,1514, ,052 4,1374, ,674 4,1224, End ofCarrying InterestCash Period ValueExpensePaid Amortization Issue104,100 Date 1103,764 4,1644, ,415 4,1514, ,052 4,1374, ,674 4,1224,500378

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Account for retirement of bonds payable. Objective 3

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Retirement of Bonds Payable l To retire a bond early, the issuer can... – purchase the bonds in the open market, or – exercise a call option. l A call option is a clause that allows the bond issuer to redeem the bonds at a specified price (usually a few points over par) on or after a specified date. l The journal entry is the same in either case.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Retirement of Bonds Payable Example $500,000 of 12% bonds with an unamortized premium of $20,000 are purchased for $498,000 and retired. Bonds Payable500,000 Premium of Bonds Payable 20,000 Cash498,000 Extraordinary Gain on Retirement of Bonds 22,000 Retired bonds payable Bonds Payable500,000 Premium of Bonds Payable 20,000 Cash498,000 Extraordinary Gain on Retirement of Bonds 22,000 Retired bonds payable

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Account for conversion of bonds payable. Objective 4

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Convertible Bonds and Notes l Convertible bonds and notes give the holder the option of exchanging the bond for a specified number of shares of common stock. l If a bond issue or a note payable is converted into common stock, stockholders’ equity is increased by the carrying amount of the bonds converted.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Current Portion of Long-Term Debt l Serial bonds and serial notes are payable in installments. l The portion payable within one year is a current liability. l The remaining debt is long term.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Mortgage Notes Payable l A mortgage is a security agreement that pledges certain assets as collateral for a note. l If it is not paid in a timely fashion, the borrower will have to transfer title to the lender. l Mortgage notes are usually paid in monthly installments.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Show the advantages and disadvantages of borrowing. Objective 5

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Equity financing creates no liabilities and no interest burden. It is less risky to the issuing corporation. It may dilute ownership interest of existing shareholders. Equity financing creates no liabilities and no interest burden. It is less risky to the issuing corporation. It may dilute ownership interest of existing shareholders. Debt financing does not dilute control. It usually results in higher earnings per share. It reduces total net income and may impose financial restrictions on the company. Debt financing does not dilute control. It usually results in higher earnings per share. It reduces total net income and may impose financial restrictions on the company. Issuing Bonds versus Stock

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Advantage of Issuing Bonds versus Stock Example l Suppose that Granite Corp., with net income of $300,000 and with 100,000 shares of common stock outstanding, needs $500,000 for expansion. l Money can be borrowed at 10% interest. l The income tax rate is 40%.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Advantage of Issuing Bonds versus Stock Example l 50,000 shares of common stock can be issued for $500,000. l Management believes that the new cash can be invested in operations to earn income of $200,000 before interest and taxes. l Should the company borrow the money or issue additional common stock?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Advantage of Issuing Bonds versus Stock Example Borrow $500,000 Expected net income on the new project$200,000 Interest expense– 50,000 Project income before taxes$150,000 Income tax expense– 60,000 Project net income$ 90,000 Net income before expansion$300,000 Total income$390,000 Expected net income on the new project$200,000 Interest expense– 50,000 Project income before taxes$150,000 Income tax expense– 60,000 Project net income$ 90,000 Net income before expansion$300,000 Total income$390,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Advantage of Issuing Bonds versus Stock Example Issue 50,000 shares of common stock at $10 per share Expected net income on the new project$200,000 Income tax expense– 80,000 Project net income$120,000 Net income before expansion$300,000 Total income$420,000 Expected net income on the new project$200,000 Income tax expense– 80,000 Project net income$120,000 Net income before expansion$300,000 Total income$420,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Advantage of Issuing Bonds versus Stock Example Borrow $500,000: $390,000 ÷ 100,000 = $3.90 earnings per share Borrow $500,000: $390,000 ÷ 100,000 = $3.90 earnings per share Issue $500,000 of common stock: $420,000 ÷ 150,000 = $2.80 earnings per share Issue $500,000 of common stock: $420,000 ÷ 150,000 = $2.80 earnings per share

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Account for lease liabilities and pension liabilities. Objective 6

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Leases l A lease is a rental agreement that allows the lessee use of an asset without a large cash down payment. l For accounting purposes there are two types of leases: 1 Operating lease 2 Capital lease

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Capital Lease l Any one of the following qualifies an agreement as a capital lease: l It transfers title at the end of the term. l It contains a bargain purchase option. l The term covers 75% or more of the estimated useful life of the asset. l The present value of the lease exceeds 90% of the market value of the asset.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Pension and Postretirement Benefits Liabilities l As the employees work, the company accrues the expense and the liability of providing benefits during retirement. l Debit Pension Expense and credit Cash. l At the end of each period, the company compares the fair market value of the pension plan assets with the accumulated benefit obligation.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Pension and Postretirement Benefits Liabilities l The accumulated benefit obligation is the amount of promised future pension payments to retirees. l If the plan is underfunded, the excess liability must be recorded as a long-term pension liability.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Appendix l What is the present value of $4,500 interest to be received for 10 periods at 5%? l The present value annuity table indicates that is the factor for 10 periods at 5%. l The present value of the future interest is $4,500 × = $34,749.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Appendix l What is the present value of a lump sum of $100,000, 10 periods from now at 5%? l The present value table indicates that.614 is the factor to be used in determining the value of $100,000 to be received 10 periods from now at 5%. l $100,000 ×.614 = $61,400

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Total present value = $34,749 + $61,400 = $96,149 What is the total present value of these amounts? Appendix

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Appendix l What is the present value of $4,500 interest to be received for 10 periods at 4%? l The present value annuity table indicates that is the factor for 10 periods at 4%. l The present value of the future interest is $4,500 × = $36,500.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Appendix l What is the present value of a lump sum of $100,000, 10 periods from now at 4%. l The present value table indicates that.676 is the factor to be used in determining the value of $100,000 to be received 10 periods from now at 4%. l $100,000 ×.676 = $67,600

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Appendix Total present value = $36,500 + $67,600 = $104,100 What is the total present value of these amounts?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber End of Chapter 15