1. Prepared by: Keri Norrie, Camosun College
ACCOUNTING PRINCIPLES
Third Canadian Edition
Prepared by: Keri Norrie, Camosun College

2. LONG-TERM LIABILITIES
CHAPTER 15
LONG-TERM LIABILITIES

3. LONG-TERM LIABILITIES
Obligations that are expected to be paid after one year
Long-term liabilities include bonds, long-term notes, and lease obligations

4. BOND BASICS
Bonds
– Form of interest-bearing notes payable issued by corporations, governments, and governmental agencies
– Sold in small denominations (usually a thousand dollars), and as a result are attractive to investors

5. WHY ISSUE BONDS? Advantages over common shares:
1. Shareholder control is not affected
2. Income tax savings result
3. Earnings per share may be higher

6. DISADVANTAGES OF BONDS
Interest must be paid on a periodic basis
Principal (face value) of the bonds must be paid at maturity

7. TYPES OF BONDS Secured and unsecured (debentures) Term and serial
Registered and bearer
Convertible
Redeemable
Retractable

8. BOND TERMINOLOGY
Face value (also termed par value or maturity value) – amount of principal due at the maturity date
Contractual interest rate (also termed coupon or stated interest rate) – rate used to determine the amount of cash interest the borrower pays and the investor receives

9. DETERMINING THE MARKET VALUE OF BONDS
Market value (present value) is a function of three factors:
Dollar amounts to be received
Length of time (n) until the amounts are received
Market rate of interest (i), which is the rate investors demand for loaning funds to the corporation
The process of finding the present value is referred to as discounting the future amounts

10. TIME DIAGRAM SHOWING CASH FLOWS (ILLUSTRATION 15-2)
$1,000,000 Principal
$25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000
10 semi-annual interest payments
Assume that on January 1, 2005, Candlestick Inc. issues $1 million of 5% bonds due in five years, with interest payable semi-annually. The purchaser of the bonds would receive two cash flows:
The principal of $1,000,000 to be paid at maturity
Ten $25,000 interest payments ($1,000,000 x 5% x 6/12 months) over the term of the bonds

11. CALCULATING THE PRESENT VALUE OF BONDS
The market value of a bond is equal to the present value of all the future cash payments promised by the bond
Present value of $1,000,000 received in 10 periods $1,000,000 x (n=10, i = 2.5%) $ 781,200
Present value of $25,000 received for each of 10 periods $25,000 x (n=10, i=2.5%) ,800
Present (market) value of bonds $1,000,000

12. ACCOUNTING FOR BOND ISSUES
Bonds may be issued at:
Face value
Discount (below face value)
Premium (above face value)

13. INTEREST RATES AND BOND PRICES (ILLUSTRATION 15-3)
Market Interest Bonds Sell
Rates at 4%
Premium
Bond Contractual Interest Rate 5%
Issued when 5%
Face Value 6%
Discount

14. ISSUING BONDS AT FACE VALUE
Bonds payable are reported in the long-term liability section of the balance sheet because the maturity date (January 1, 2010, in this case) is more than one year away.
Date
Account Titles and Explanation
Debit
Credit
Jan. 1
Cash
1,000,000
Bonds Payable
To record sale of bonds at face value.

15. ISSUING BONDS AT FACE VALUE
Assuming that interest is payable semi-annually on January 1 and July 1 on the bonds, interest of $25,000 ($1,000,000 x 5% x 6/12) must be paid on July 1, The entry for the payment is:
Date
Account Titles and Explanation
Debit
Credit
July 1
Bond Interest Expense
25,000
Cash
To record payment of bond interest.

16. ISSUING BONDS AT A DISCOUNT
Assume that on January 1, 2005, Candlestick Inc. sells $1 million, five-year, 5% bonds at ( % of face value) with interest payable on July 1 and January 1. The entry to record the issue is:
Date
Account Titles and Explanation
Debit
Credit
Jan. 1
Cash
957,345
Discount on Bonds Payable
42,655
Bonds Payable
1,000,000
To record payment of bond interest.

17. ISSUING BONDS AT A DISCOUNT
While Candlestick borrowed $957,245 now…
Discount of $42,655 is an additional cost of borrowing.
...it must repay $1,000,000 at the end of five years in addition to the contractual interest rate.
The total cost of borrowing $957,245 is:
Semi-annual interest payments
($25,000 x 10 periods)
Add: Bond Discount
$250,000
42,655
$292,655
This borrowing cost is recorded as interest expense over the life of the bond. Appendix 15A and 15B discuss the two methods for allocating the cost.

18. STATEMENT PRESENTATION OF BOND DISCOUNT
While the Discount on Bonds Payable account has a debit balance, it is not an asset. Rather, it is a contra liability account that is deducted from Bonds Payable on the balance sheet, as illustrated below:
Long-term liabilities
Bonds payable
Less: Discount on bonds payable
$1,000,000
42,655 $957,345
The $957,345 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds.

19. ISSUING BONDS AT A PREMIUM
To illustrate issuing bonds at a premium, assume that on January 1, 2005, Candlestick Inc. sells $1 million, five-year, 5% bonds at ( % of face value) with interest payable on July 1 and January 1. The entry to record the issue is:
Date
Account Titles and Explanation
Debit
Credit
Jan. 1
Cash
1,044,915
Bonds Payable
1,000,000
Premium on Bonds Payable
44,915
To record sale of bonds at a premium.

20. ISSUING BONDS AT A PREMIUM
While Candlestick borrowed $1,044,915 now…
Premium of $44,915 reduces the cost of borrowing.
...it must repay $1,000,000 at the end of five years in addition to the contractual interest rate.
The total cost of borrowing $1044,915 is:
Semi-annual interest payments
($25,000 x 10 periods)
Less: Bond Premium
$250,000
44,915
$205,085
This borrowing cost is recorded as interest expense over the life of the bond. Appendix 15A and 15B discuss the two methods for allocating the cost.

21. STATEMENT PRESENTATION OF BONDS PREMIUM
Premium on Bonds Payable has a credit balance and therefore is added to Bonds Payable on the balance sheet, as illustrated below:
Long-term liabilities
Bonds payable
Add: Premium on bonds payable
$1,000,000
44,915 $1,044,915
The $1,044,915 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds.

22. REDEEMING BONDS AT MATURITY
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:
Date
Account Titles and Explanation
Debit
Credit
Jan. 1
Bonds Payable
1,000,000
Cash
To record redemption of bonds at maturity.

23. BOND RETIREMENTS
Bonds may be redeemed before maturity because a company may decide to reduce interest cost and remove debt from its balance sheet.
Assume that Candlestick retires its bond at 103 on January 1, 2009, after the eighth interest payment when the carrying value of the bond is $1,008,983.
Date
Account Titles and Explanation
Debit
Credit
Jan. 1
Bonds Payable
1,000,000
Premium on Bonds Payable
8,983
Loss on Bond Redemption
21,017
Cash (1,000,000 x 103%)
1,030,000

24. NOTES PAYABLE Long-term notes payable:
Similar to short-term interest-bearing notes payable except that the term of the note exceeds one year
May be secured by specific assets, which are commonly referred to as mortgages
Have instalment payments that usually take one of two forms: Fixed principal payments plus interest, or - Blended principal and interest payments

25. INSTALMENT PAYMENT SCHEDULE FIXED PRINCIPAL PAYMENT (ILLUSTRATION 15-7)
To illustrate, assume that Belanger Ltd. issues a $120,000, 7%, five-year note on January 1, 2005, to obtain needed financing for the construction of a new research laboratory. The terms provide for monthly instalment payments of $2,000 ($120,000/60). The instalment payment schedule for the first few months is shown below:
(A) (B) (C) (D)
Cash Interest Reduction Principal Interest Payment Expense of Principal Balance Period (B + C) (D x 7% x 1/12) (120,000/60) ( D - C )
Issue date $120,000
$2,700 $ $2, ,000
, , ,000
, , ,000

26. INSTALMENT PAYMENT SCHEDULE BLENDED PAYMENT (ILLUSTRATION 15-8)
To illustrate, assume that instead of fixed principal payments, Belanger Ltd. repays its $120,000, 7%, five-year note payable in equal monthly instalments of $2,376. The instalment payment schedule for the first few months is shown below:
(B) (C) (D)
(A) Interest Reduction Principal Interest Cash Expense of Principal Balance Period Payment (D x 7% x 1/12) (A - B) ( D - C )
Issue date $120,000
$2,376 $ $1, ,324
, , ,638
, , ,942
With both types of instalment notes payable, the reduction in principal for the next year must be reported as a current liability, while the remaining unpaid principal is classified as a long-term liability.

27. LEASE LIABILITIES
A lease is a contractual arrangement between a lessor (owner of a property) and a lessee (renter of a property). There are two types of leases:
Operating Lease
Temporary use of the property by lessee
The lease payments are recorded as an expense by the lessee, as revenue by the lessor
The property remains on the books of the lessor
The risks and benefits of ownership remain with the lessor
Capital Lease
In substance, the lessee has “purchased” the property from the lessor on credit
The property and lease liability are recorded on the books of the lessee at the present value of the lease payments
The risks and benefits of ownership transfer to the lessee

28. LEASE LIABILITIES
A lessee must classify a lease as a capital lease if any one of the following conditions exist:
- Lease transfers ownership of the property to the lessee (e.g. contains a bargain purchase option)
- Lease term is equal to 75% or more of the economic life of the leased property
- Present value of the lease payments equals or exceeds 90% of the fair market value of the leased property

29. OFF-BALANCE SHEET FINANCING
LEASE LIABILITIES
OFF-BALANCE SHEET FINANCING
Lessees usually do not want to report leases as capital leases.
- Capital leases report higher liabilities, which may make it more difficult to borrow funds from lenders
- To avoid recording the liability, a company may structure the lease to avoid meeting the criteria for capital leases
- The practice of keeping liabilities off the balance sheet is called off-balance sheet financing
- Note disclosure assists users in assessing the lease implications

30. DEBT TO TOTAL ASSETS
The debt-to-total-assets ratio indicates the percentage of total assets owed to creditors, providing one measure of leverage. It is calculated by dividing total debt by total assets.
Total Debt
Total Assets
Debt to Total Assets  

31. INTEREST COVERAGE RATIO
The interest coverage ratio measures the company’s ability to meet interest payments as they come due. It is calculated as follows:
Net Income + Interest Expense + Income Tax Expense
Interest Expense
Interest Coverage  

32. STRAIGHT-LINE AMORTIZATION (APPENDIX 15A-1)
The straight-line method of amortization allocates the same amount of bond discount or premium to interest expense each interest period. The amount is calculated as follows:  =
Bond
Discount/
Premium
Number of Interest Periods
Amortization Amount

33. AMORTIZING A BOND DISCOUNT (APPENDIX 15A-2)
From the Candlestick Inc. example used previously, the discount of $42,655 is amortized to interest expense over 10 periods or $4,265 per period. The entry on the first interest date (July 1, 2005) is:
Date
Account Titles and Explanation
Debit
Credit
July 1
Bond Interest Expense
29,265.50
Discount on Bonds Payable
4,265.50
Cash
25,000.00
To record payment of bond interest and amortization of bond discount.

34. AMORTIZING A BOND PREMIUM (APPENDIX 15A-3)
Amortizing Candlestick’s bond premium of $44,915 parallels the calculation for discounts except that the premium decreases the interest expense. The entry for July 1, 2005 is:
Date
Account Titles and Explanation
Debit
Credit
July 1
Bond Interest Expense
20,508.50
Premium on Bonds Payable ($44,915 ÷ 10)
4,491.50
Cash
25,000.00
To record payment of bond interest and amortization of bond premium.

35. EFFECTIVE-INTEREST AMORTIZATION (APPENDIX 15B-2)
The effective-interest method of amortization results in periodic interest expense equal to a constant percentage of the bond’s carrying value. The amount of premium/discount amortization is calculated as follows:
Bond Interest Expense
Bond Interest Paid
Amortization
Amount
Carrying value of Bonds at
Beginning of Period
Market x Interest
Rate
Face Amount of Bonds
Contractual Interest Rate   

36. AMORTIZING A BOND DISCOUNT (APPENDIX 15B-3)
From the Candlestick Inc. example used previously, the bond was issued for $957,345. This bond is issued to yield a market interest rate of 6%. The entry on the first interest date (July 1, 2005) is:
Date
Account Titles and Explanation
Debit
Credit
July 1
Bond Interest Expense (6% x $957,345 x 6/12)
28,720
Discount on Bonds Payable
3,720
Cash (same for either method)
25,000
To record payment of bond interest and amortization of bond discount.
While more complex than the straight-line method, the effective-rate method is conceptually superior, since interest expense as a percentage of carrying value remains the same each period.

37. AMORTIZING A BOND PREMIUM (APPENDIX 15B-4)
From the Candlestick Inc. example used previously, the bond was issued for $1,044,915. This bond is issued to yield a market interest rate of 4%. The entry on the first interest date (July 1, 2005) is:
Date
Account Titles and Explanation
Debit
Credit
July 1
Bond Interest Expense (4% x $1,044,915 x 6/12)
20,898
Premium on Bonds Payable
4,102
Cash (same for either method)
25,000
To record payment of bond interest and amortization of bond premium.
Both Straight-Line and Effective-Rate methods result in same total interest expense over the term of the bonds. If the calculations are materially different per period, then the Effective-Rate method is to be used.

38. COPYRIGHT
Copyright © 2004 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.