John Wiley & Sons, Inc. © 2005 Chapter 16 LONG-TERM LIABILITIES Prepared by Naomi Karolinski Monroe Community College and and Marianne Bradford Bryant College Accounting Principles, 7 th Edition Weygandt Kieso Kimmel

CHAPTER 16 LONG-TERM LIABILITIES After studying this chapter, you should be able to: 1 Explain why bonds are issued. 2 Prepare the entries for the issuance of bonds and interest expense. 3 Describe the entries when bonds are redeemed or converted. 4 Describe the accounting for long-term notes payable. 5 Contrast the accounting for operating and capital leases. 6 Identify the methods for the presentation and analysis of long-term liabilities.

Long-Term Liabilities Obligations that are expected to be paid after one year Include bonds, long-term notes, and lease obligations

Bond Basics STUDY OBJECTIVE 1 Bonds –interest-bearing notes payable –issued by corporations, universities, and governmental agencies –like common stock, can be sold in small denominations (usually a thousand dollars) –attract many investors To obtain large amounts of long-term capital, corporate management usually must decide whether to issue bonds or to use equity financing (common stock).

Why Issue Bonds? Long-term financing, bonds, offer the following advantages over common stock: 1)Stockholder control not affected 2)Tax savings 3)Earnings per share may be higher

Disadvantages of Bonds 1)Interest must be paid on a periodic basis 2)Principal (face value) must be repaid at maturity

1) Secured bonds Specific assets of the issuer pledged as collateral for the bonds( a mortgage bond is secured by real estate) 2) Unsecured bonds Issued against the general credit of the borrower; they are also called debenture bonds. Types of Bonds Secured and Unsecured

3) Term bonds bonds that mature at a single specified future date 4) Serial bonds bonds that mature in installments Types of Bonds: Term and Serial Bonds Registered

Types of Bonds: Registered and Bearer 5)Registered bonds issued in the name of the owner and have interest payments made by check to bondholders of record 6)Bearer or coupon bonds not registered; thus bondholders must send in coupons to receive interest payments Pay to: Bearer Registered Pay to: Joe Smith

Types of Bonds Convertible and Callable Convertible –convert the bonds into common stock at holder’s option Callable –subject to call and retirement at a stated dollar amount prior to maturity at the option of the issuer

Authorizing a Bond Issue State laws grant corporations the power to issue bonds –approval by both the Board of Directors and stockholders is usually required Board of Directors stipulate the number of bonds to be authorized, total face value, and contractual interest rate

Issuing Procedures Face value –amount of principal the issuer must pay at the maturity date Contractual interest rate, or stated rate –rate used to determine the amount of cash interest the borrower pays and the investor receives Bond indenture –terms of the bond issue are set forth in a formal legal document Bond certificates –Printed document providing information such as name of issuer and maturity date

Bond Certificate

Bond Trading Corporate bonds –traded on national securities exchanges –bondholders have the opportunity to convert their holdings into cash by selling the bonds at the current market price Bond prices are quoted as a percentage of the face value of the bond (usually $1,000). Transactions between a bondholder and other investors are not journalized by the issuing corporation. A corporation only makes journal entries when it issues or buys back bonds, and when bondholders convert bonds into common stock.

Determining the Market Value of Bonds The market value (present value) of a bond is determined by: 1) the dollar amounts to be received 2) the length of time until the amounts are received 3) the market rate of interest, which is the rate investors demand for loaning funds. The process of finding the present value is referred to as discounting the future amounts.

Accounting for Bond Issues Issuing Bonds at Face Value STUDY OBJECTIVE 2 1,000,000 1,000,000 Bonds may be issued at face value, below face value (at a discount), or above face value (at a premium). They also are sometimes issued between interest dates. Assume that Devor Corporation issues 1,000, 10-year, 9% $1,000 bonds dated January 1, 2005, at 100 (100% of face value). The entry to record the sale is: Bonds payable are reported in the long-term liability section of the balance sheet because the maturity date is more than one year away.

Accounting for Bond Issues Issuing Bonds at Face Value 45,000 45,000 Assuming that interest is payable semiannually on January 1 and July 1 on the bonds, interest of $45,000 ($1,000,000 x 9% x 6/12)must be paid on July 1, The entry for the payment is:

Accounting for Bond Issues Issuing Bonds at Face Value 45,000 At December 31, an adjusting entry is required to recognize the $45,000 of interest expense incurred since July 1. The entry is: Bond interest payable is classified as a current liability, because it is scheduled for payment within the next year. When interest is paid on January 1, 2006, Bond Interest Payable is debited, and Cash is credited for $45,000 in order to eliminate the liability.

Interest Rates and Bond Prices BOND CONTRACTUAL INTEREST RATE 10% Issued when: 8% 10% 12% Premium Face Value Discount Market Rates Bonds Sell at:

Accounting for Bond Issues Discount or Premium on Bonds Bonds may be issued below or above face value. Market (effective) rate of interest is higher than the contractual (stated) rate –the bonds will sell at less than face value, or at a discount Market rate of interest is less than the contractual rate – the bonds will sell above face value, or at a premium

Issuing Bonds at a Discount Assume that on January 1, 2005, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $92,639 (92.639% of face value) with interest payable on July 1 and January 1. The entry to record the issuance is:

The $92,639 represents the carrying (or book) value of the bonds. On the date of issue this amount equals the market price of the bonds. Statement Presentation of Discount on Bonds Payable Although Discount on Bonds Payable has a debit balance, it is NOT an asset. Rather, it is a contra account, which is deducted from bonds payable on the balance sheet, as illustrated below:

Total Cost of Borrowing - Bonds Issued at Discount The difference between the issuance price and face value of the bonds-the discount-is an additional cost of borrowing that should be recorded as bond interest expense over the life of the bonds. The total cost of borrowing, $92,639 for Candlestick, Inc., is $57,361, as computed as follows:

Alternative Computation of Total Cost of Borrowing - Bonds Issued at a Discount Alternatively, the total cost of borrowing can be computed as follows: Total cost of borrowing $57,361

Issuing Bonds at a Premium We now assume the Candlestick, Inc. bonds described in the previous slides are sold for $108,111 ( % of face value) rather than for $ 92, , ,000 8,111

Statement Presentation of Bond Premium Premium on bonds payable is added to bonds payable on the balance sheet, as shown below:

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid. The premium is considered to be a reduction in the cost of borrowing that should be credited to Bond Interest Expense over the life of the bonds. Total Cost of Borrowing - Bonds Issued at a Premium

Alternative Computation of Total Cost of Borrowing - Bonds Issued at a Premium Alternatively, the total cost of borrowing can be determined as follows: Total cost of borrowing $41,889

Redeeming Bonds at Maturity STUDY OBJECTIVE 3 1,000,000 1,000,000 Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the interest for the last interest period is paid and recorded separately, the entry to record the redemption of the Candlestick bonds at maturity is:

Bond Retirements Company decides to reduce interest cost and remove debt from its balance sheet. 1)Eliminate the carrying value of the bonds at the redemption date. 2)Record the cash paid. 3)Recognize the gain or loss on redemption.

Redeeming Bonds Before Maturity Assume that at the end of the eighth period, Candlestick, Inc. retires its bonds at 103 after paying the semiannual interest. The carrying value of the bonds at the redemption date is $101,623. The entry to record the redemption at the end of the eighth interest period (January 1, 2009) is: 100,000 1,623 1, ,000

The term used for bonds that are unsecured is: a. callable bonds. b. indenture bonds. c. debenture bonds. d. bearer bonds. Chapter 16

The term used for bonds that are unsecured is: a. callable bonds. b. indenture bonds. c. debenture bonds. d. bearer bonds. Chapter 16