1. Chapter 11 Long-Term Liabilities
Belverd E. Needles, Jr.
Marian Powers
Multimedia Slides by:
Dr. Howard A. Kanter, CPA
DePaul University
Milton M. Pressley
University of New Orleans

2. LEARNING OBJECTIVES
1. Identify the management issues related to issuing long-term debt.
2. Identify and contrast the major characteristics of bonds.
3. Record the issuance of bonds at face value and at a discount or premium.
4. Use present values to determine the value of bonds.
5. Use the straight-line and effective interest methods to amortize (a) bond discounts and (b) bond premiums.

3. LEARNING OBJECTIVES (continued)
6. Account for bonds issued between interest dates and make year-end adjustments.
7. Account for the retirement of bonds and the conversion of bonds into stock.
8. Explain the basic features of mortgages payable, installment notes payable, long-term leases, and pensions and other postretirement benefits as long-term liabilities.

4. Management Issues Related to Issuing Long-Term Debt
OBJECTIVE 1
Identify the management issues related to issuing long-term debt.

5. Reasons for Long-Term Liabilities
Long-term liabilities are obligations of business that are due to be paid after one year or beyond the operating cycle, whichever is longer.
Decisions related to long-term debt are critical because how a company finances its operations is the most important factor in the company’s long-term viability.
The amount and type of debt a company incurs depends on many factors, including the nature of the business, its competitive environment, the state of the financial markets, and the predictability of its earnings.

6. Reasons and Resources for Long-Term Debt
Growing businesses frequently need long-term financing to invest in R&D activities and long-term assets.
Two key sources of long-term funds:
1. Issuance of capital stock.
2. Issuance of long-term debt such as bonds, notes, mortgages, and leases.
Related management issues:
Whether or not to have long-term debt.
How much long-term debt to have.
What types of long-term debt to have.

7. The Decision to Issue Long-Term Debt
Key management decision is whether to rely solely on stockholders’ equity or to rely partially on long-term debt for long-term funds.
Advantages of common stock over debt.
It does not have to be paid back.
Dividends are paid only if the company earns sufficient income.
Advantages of long-term debt over common stock.
Stockholder control.
Tax effects.
Financial leverage.

8. Disadvantages of Debt Financing
Cash is required to make periodic interest payments and to pay back the principal amount.
Company can become overcommited.
Financial leverage can work against a company if the earnings from its investments do not exceed its interest payments.
Managers must know the characteristics of the various types of long-term liabilities so that they can structure a company’s long-term financing to the best advantage of the company.

9. How Much Debt
The use of debt financing varies widely across industries.
Failure to make timely payments could force a company into bankruptcy.
The interest coverage ratio (ICR) is a measure of how much risk a company is undertaking with its debt.
The ICR measures the degree of protection a company has from default on interest payments.

10. How Much Debt
The use of debt financing varies widely across industries.
Failure to make timely payments could force a company into bankruptcy.
The interest coverage ratio (ICR) is a measure of how much risk a company is undertaking with its debt.
The ICR measures the degree of protection a company has from default on interest payments.
Income Before Taxes + Interest Expense
Interest Expense
ICR =

11. Types of Long-Term Debt
Long-term bonds (debentures) have different characteristics.
Time until repayment.
Amount of interest.
Ability to repay early.
Conversion into other securities.
Other types of long-term debt.
Long-term notes.
Mortgages.
Long-term leases.

12. OBJECTIVE 2 Identify and contrast the major characteristics of bonds.
The Nature of Bonds
OBJECTIVE 2
Identify and contrast the major characteristics of bonds.

13. The Nature of Bonds
A bond is a security, usually long term, representing money borrowed from the investing public by a corporation or some other entity.
Bonds must be repaid at a certain time and require periodic (usually semiannual) payments of interest.
Bondholders are creditors.
Bonds are promises to repay the amount borrowed (principal) and interest at a specified rate on specified future dates.

14. The Nature of Bonds (continued)
The bondholder receives a bond certificate as evidence of the company's debt.
A bond issue is the total number of bonds issued at one time.
A bond indenture defines the rights, privileges, and limitations of the bondholders.
The bond indenture describes the maturity date, interest payment dates, interest rate, and characteristics of the bonds.

15. The Nature of Bonds (continued)
The price of bonds is stated in terms of a percentage of face value.
A quote of 103 1/2 means the price is $1,035 per $1,000 bond.

16. Bond Features
A bond indenture is written to fit the financing needs of a business.
Bonds may have several features.
Secured or unsecured.
Term or serial.
Registered or coupon.

17. Secured or Unsecured Bonds
Unsecured (debentures) are issued based on the company’s credit rating.
Secured bonds give bondholders a pledge of certain assets as a guarantee of repayment.

18. Term or Serial Bonds Term bonds all mature at the same time.
Serial bonds mature on several different dates.

19. Registered or Coupon Bonds
Registered bondholders are recorded with the issuing company. Interest is paid by check.
Coupon bonds are not registered with the corporation; instead, they bear interest coupons stating the amount of interest due and the payment date.
The bondholder removes the coupons from the bonds on the interest payment dates and presents them at a bank for collection.

20. Accounting for Bonds Payable
OBJECTIVE 3
Record the issuance of bonds at face value and at a discount or premium.

21. Accounting for Bonds Payable
When the board of directors decides to issue bonds, it presents the proposal to the stockholders for approval.
Certificates and bond agreement are prepared.
When bonds are authorized, no journal entry is required.
Normally, a memo entry is made giving the particulars of the bond issue.

22. Balance Sheet Disclosure of Bonds
Bonds are disclosed on the balance sheet in one of two ways under long-term liabilities.
1. Bonds payable.
2. Unamortized premiums or discounts.

23. Important Provisions of the Bond Indenture
Important provisions of the bond indenture are reported in the notes to the financial statements.
List of bond issues.
Kinds of bonds.
Interest rates.
Any securities connected with the bonds.
Interest payment dates.
Maturity dates.
Effective interest rates.

24. Bonds Issued at Face Value
Jan. 1 Cash ,000
Bonds Payable ,000
Sold $100,000 of 9%,
5-year bonds at
face value

25. Bonds Issued at Face Value
Jan. 1 Cash ,000
Bonds Payable ,000
Sold $100,000 of 9%,
5-year bonds at
face value
July 1 Bond Interest Expense 4,500
Cash ,500
Semiannual interest
$100,000 x .09 x 6/12 year

26. Bonds Issued at a Discount
Jan. 1 Cash ,149
Unamortized Bond Discount ,851
Bonds Payable ,000

27. Bonds Issued at a Discount
Jan. 1 Cash ,149
Unamortized Bond Discount ,851
Bonds Payable ,000
Sold $100,000 of
9%, 5-year bonds at
Face amount of bonds $100,000
Less purchase price ,149
Unamortized bond discount $ 3,851

28. Bonds Issued at a Premium
Jan. 1 Cash ,100
Unamortized Bond
Premium 4,100
Bonds Payable ,000

29. Bonds Issued at a Premium
Jan. 1 Cash ,100
Unamortized Bond
Premium 4,100
Bonds Payable ,000
Sold $100,000 of
9%, 5-year bonds at 104.1
Purchase price $104,100
Less face amount ,000
Unamortized premium $ 4,100

30. Bond Issue Costs Fees to underwriters.
Amortized over the life of the bonds in a separate account.
Bond issue costs decrease the amount of cash received.
Increase bond discount.
Decrease bond premium.
Bond issue costs can be spread over the life of the bonds through the amortization of a discount or premium.

31. Using Present Value to Value a Bond
OBJECTIVE 4
Use present values to determine the value of bonds.

32. Using Present Value to Value a Bond
1. A series of fixed interest payments.
2. A single payment at maturity.
Present value is relevant to the study of bonds because the value of a bond is based on the present value of two components of cash flow:

33. Using Present Value to Value a Bond
1. A series of fixed interest payments.
2. A single payment at maturity.
The amount of interest a bond pays is fixed over its life.
Present value is relevant to the study of bonds because the value of a bond is based on the present value of two components of cash flow:

34. Influence of the Market Interest Rate
The market interest rate varies from day to day and therefore what investors are willing to pay changes as well.
If the current market interest rate is now greater than the bond’s interest rate:
Investors are willing to pay less.
If the current market interest rate is now less than the bond’s interest rate:
Investors are willing to pay more.

35. Amortizing a Bond Discount
OBJECTIVE 5a
Use the straight-line and effective interest methods to amortize bond discounts.

36. Bond Discount Issues
When a bond is sold at a discount, the discount affects interest expense in each year of the of the bond issue.
Discount should be amortized over the life of the issue.
Unamortized bond discount decreases gradually over time.
Carrying value increases gradually.
By maturity date:
The carrying value of the issue equals the face value amount of the bonds.
The unamortized bond discount is zero.

37. Calculation of Total Interest Cost
When bonds are sold at a discount, the effective interest rate paid by the company is greater than the face interest rate on the bonds.
Interest Cost = Stated Interest + Bond Discount.
Actual Interest Expense =
(Issue Price - Face Value) + Total Interest Payments.

38. Calculation of Total Interest Cost
When bonds are sold at a discount, the effective interest rate paid by the company is greater than the face interest rate on the bonds.
Interest Cost = Stated Interest + Bond Discount.
Actual Interest Expense =
(Issue Price - Face Value) + Total Interest Payments.
Cash to be paid to bondholders
Face value at maturity $100,000
Interest payments ,000
Total cash to be paid $145,000
Less cash received ,149
Total interest cost $ 48,851

39. Accounting for Total Interest Cost
Effective Interest Rate = Stated Rate + Discount.
The discount must be allocated over the remaining life of the bonds as an increase in the interest expense each period; this is amortization of the bond discount.
The interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period.
Zero coupon bonds are issued by some companies and governmental units.
They do not require periodic interest payments.
They represent a promise to pay a fixed amount at the maturity date.

40. Methods of Amortizing a Bond Discount
Straight-line method.
Effective interest method.

41. Carrying Value and Interest Expense - Bonds Issued at a Discount
Years
$96,149
$100,000
Carrying Value 5
0.5 1
1.5 2
2.5 3
3.5 4
4.5
Face value
Carrying value = face value - unamortized discount
$4,500
Interest Expense
$4,807
$4,961
UNAMORTIZED DISCOUNT
Interest expense = carrying value x market interest rate x time
Interest payments = face value x face interest rate x time
BOND DISCOUNT AMORTIZED

42. Amortizing a Bond Premium
OBJECTIVE 5b
Use the straight-line and effective interest methods to amortize bond premiums.

43. Total Interest Cost
A bond premium represents an amount that bondholders will not receive at maturity.
The premium is a reduction, in advance, of the total interest paid on the bonds over the life of the bond issue.

44. Calculation of Total Interest Cost
Cash to be paid to bondholders
Face value at maturity $100,000
Interest payments ($100,000 x .09 x 5yrs) ,000
Total cash paid to bondholders $145,000
Less cash received from b/h ,100
Total interest cost $ 40,900

45. Calculation of Total Interest Cost
Cash to be paid to bondholders
Face value at maturity $100,000
Interest payments ($100,000 x .09 x 5yrs) ,000
Total cash paid to bondholders $145,000
Less cash received from b/h ,100
Total interest cost $ 40,900
Total interest payments of $45,000 exceed the total interest costs of $40,900 by $4,100, the amount of the bond premium.

46. Straight-Line Method of Amortizing a Bond Premium
Bond premium is spread evenly over the life of the bond issue.
Bond Interest = Stated Interest - Premium.

47. Straight-Line Method of Amortizing a Bond Premium
Bond premium is spread evenly over the life of the bond issue.
Bond Interest = Stated Interest - Premium.
July 1 Bond Interest Expense ,090
Unamortized Bond Premium
Cash (or Interest Payable) 4,500
Paid (or accrued)
semiannual interest and
amortized premium on
9%, 5-year bonds

48. Effective Interest Method of Amortizing a Bond Premium
The interest expense decreases slightly each period because the amount of the bond premium amortized increases slightly each period. July 1 Bond Interest Expense 4,164
Unamortized Bond Premium
Cash ,500

49. Effective Interest Method of Amortizing a Bond Premium
The interest expense decreases slightly each period because the amount of the bond premium amortized increases slightly each period. July 1 Bond Interest Expense 4,164
Unamortized Bond Premium
Cash ,500
Paid (or accrued) semiannual
interest to bondholders and
amortized premium on 9%,
5-year bonds

50. Carrying Value and Interest Expense - Bonds Issued at a Premium
Years
$100,000
$104,100
Carrying Value 5
0.5 1
1.5 2
2.5 3
3.5 4
4.5
UNAMORTIZED PREMIUM
$3,955
Interest Expense
$4,164
$4,500
BOND PREMIUM AMORTIZED
Carrying value = face value + unamortized premium
Interest payments = face value x face interest rate x time
Face value
Interest expense = carrying value x market interest rate x time

51. Other Bonds Payable Issues
OBJECTIVE 6
Account for bonds issued between interest dates and make year-end adjustments.

52. Sale of Bonds Between Interest Dates
Generally accepted method is to collect from investors the interest that would have accrued for the partial period preceding the issue date.
When the first interest period is completed, the corporation pays investors the interest for the entire period.
This procedure is followed for two reasons: 1. Decreases bookkeeping for sales at various dates. 2. When the accrued amount is netted against the full interest paid on the interest payment date, the result is the interest expense for the time the money was borrowed.

53. Accounting for Sale of Bonds Between Interest Dates
May 1 Cash ,000
Bond Interest Expense ,000
Bonds Payable ,000
Sold 9%, 5-year bonds
at face plus 4 months’
accrued interest
$100,000 x .09 x 4/12 = $3,000
Notes:
.09 = $750 per month
interest for four months = 4 * 750 = 3,000
__Bond Interest Expense______________
7/ | 5/1 3,000
1500 (2 months interest May and June
_Cash ____________
5/ , | 7/ |
98, , months interest of 1500

54. Accounting for Sale of Bonds Between Interest Dates
May 1 Cash ,000
Bond Interest Expense ,000
Bonds Payable ,000
Sold 9%, 5-year bonds
at face plus 4 months’
accrued interest
$100,000 x .09 x 4/12 = $3,000
July 1 Bond Interest Expense ,500
Cash ,500
Paid semiannual interest
$100,000 x .09 x 6/12 = $4,500
Notes:
.09 = $750 per month
interest for four months = 4 * 750 = 3,000
__Bond Interest Expense______________
7/ | 5/1 3,000
1500 (2 months interest May and June
_Cash ____________
5/ , | 7/ |
98, , months interest of 1500

55. Effect on Bond Interest Expense
When Bonds Are Issued Between Interest Dates
January 1, 19x0
July 1, 19x0
Bond interest paid to buyer at
interest payment date = $4,500
Accrued bond interest
paid by buyer at
issuance = $3,000
Bond interest expense
to issuer = $1,500
Date of
issuance
May 1, 19x0

56. Accounting for Year-End Accrual for Bond Interest Expense
9/30/x0 Bond Interest Expense 2,075.50
Unamortized Bond
Premium
Interest Payable ,250.00

57. Accounting for Year-End Accrual for Bond Interest Expense
9/30/x0 Bond Interest Expense 2,075.50
Unamortized Bond
Premium
Interest Payable , To record accrual of interest on
9% bonds payable for 3 months
and amortization of half of the
premium for the second interest
payment period

58. 1/1/x1 Bond Interest Expense 2,075.50
Interest Payable 2,250.00
Unamortized Bond
Premium
Cash ,500.00

59. 1/1/x1 Bond Interest Expense 2,075.50 Interest Payable 2,250.00
Unamortized Bond
Premium
Cash ,500.00
Paid semiannual interest
including interest previously
accrued, and amortized the
premium for the period since
the end of the fiscal year

60. Retirement of Bonds OBJECTIVE 7
Account for the retirement of bonds and the conversion of bonds into stock.

61. Retirement of Bonds
Most bond issues give the corporation a chance to buy back and retire the bonds at a call price, usually above face value, before maturity.
Such bonds are known as callable bonds.
The retirement of a bond issue before its maturity date is called early extinguishment of debt.

62. Accounting for Retirement of Bonds
July 1 Bonds Payable ,000
Unamortized Bond Premium ,447
Loss on Retirement of Bonds ,553
Cash ,000
Retired 9% bonds at 105

63. Conversion of Bonds into Common Stock
Convertible bonds can be exchanged for other securities of the corporation.
Convertibility enables an investor to make more money because if the market price of the common stock rises, the value of the bonds rises.
If the stock price does not rise, the investor still holds the bonds and receives both interest payments and principal at the maturity date.
Notes:
100,000 of bonds / $1000 = 100 to Convert
100 * 40 shares each = 4,000 $8 par = $32,000
BP 100,000
+ Uam Prem 1,447
101,447
- Par (32000)
69,447

64. Accounting for Conversion of Bonds into Common Stock
July 1 Bonds Payable ,000
Unamortized Bond Premium ,447
Common Stock ,000
Paid-in Capital in Excess
of Par Value, Common 69,447
Notes:
100,000 of bonds / $1000 = 100 to Convert
100 * 40 shares each = 4,000 $8 par = $32,000
BP 100,000
+ Uam Prem 1,447
101,447
- Par (32000)
69,447

65. Accounting for Conversion of Bonds into Common Stock
July 1 Bonds Payable ,000
Unamortized Bond Premium ,447
Common Stock ,000
Paid-in Capital in Excess
of Par Value, Common 69,447
Converted 9% bonds payable
into $8 par value common stock
at a rate of 40 shares for each
$1,000 bond
Notes:
100,000 of bonds / $1000 = 100 to Convert
100 * 40 shares each = 4,000 $8 par = $32,000
BP 100,000
+ Uam Prem 1,447
101,447
- Par (32000)
69,447

66. Other Long-Term Liabilities
OBJECTIVE 8
Explain the basic features of mortgages payable, installment notes payable, long-term leases, and pensions and other postretirement benefits as long-term liabilities.

67. Mortgages Payable
A mortgage is a long-term debt secured by real property, usually paid in equal monthly installments.

68. Mortgages Payable
A mortgage is a long-term debt secured by real property, usually paid in equal monthly installments.
July 1 Mortgage Payable 300
Mortgage Interest Expense 500
Cash
Made monthly mortgage
payment

69. Installment Notes Payable
Installment notes payable occur when the terms of a note call for a series of periodic payments.
Each payment includes the interest plus a repayment of part of the amount that was borrowed.
On 12/31/x1, $100,000 is borrowed on a 15%, 5-year installment note. 12/31/x1 Cash , Notes Payable ,000

70. Installment Notes Payable
Installment notes payable occur when the terms of a note call for a series of periodic payments.
Each payment includes the interest plus a repayment of part of the amount that was borrowed.
On 12/31/x1, $100,000 is borrowed on a 15%, 5-year installment note. 12/31/x1 Cash , Notes Payable ,000
Borrowed $100,000
at 15% on a 5-year
installment note

71. Payments of Accrued Interest Plus Equal Amounts of Principal
12/31/x2 Notes Payable 20,000
Interest Expense 15,000
Cash ,000
Made first installment
payment on note
$100,000 x .15 = $15,000

72. Payments of Accrued Interest Plus Equal Amounts of Principal
12/31/x2 Notes Payable 20,000
Interest Expense 15,000
Cash ,000
Made first installment
payment on note
$100,000 x .15 = $15,000
12/31/x3 Notes Payable 20,000
Interest Expense 12,000
Cash ,000
Made second installment
$80,000 x .15 = $12,000

73. Payments of Accrued Interest Plus Increasing Amounts of Principal
12/31/x2 Notes Payable 14,833
Interest Expense 15,000
Cash ,833
Made first installment
payment on note

74. Payments of Accrued Interest Plus Increasing Amounts of Principal
12/31/x2 Notes Payable 14,833
Interest Expense 15,000
Cash ,833
Made first installment
payment on note
12/31/x3 Notes Payable 17,058
Interest Expense 12,775
Made second installment

75. Long-Term Leases
There are several ways for a company to obtain new operating assets.
1. Borrow money and buy the asset.
Asset and liability are recorded at the amount paid.
Asset is subject to periodic depreciation.
2. Rent the asset on a short-term lease.
Operating lease.
Risks of ownership remain with the lessor.
3. Obtain the asset on a long-term lease.
Requires no immediate cash payment.
Rental payment is deducted in full for tax purposes.
Cost is less than a short-term lease.

76. Related Accounting Challenges for Long-Term Leases
Often the lease cannot be canceled.
Duration of the lease may be about the same as the useful life of the asset.
There may be a provision for the lessee to buy the asset at the end of the lease term.
Similar to an installment purchase.

77. Capital Leases
A capital lease is more like a purchase or installment sale.
The lessee must record an asset and a long-term liability equal to the present value of the lease payments over the lease term.
Each lease payment consists of interest and repayment of debt.
Depreciation is computed on the asset.
A lease is recorded as follows:

78. Capital Leases
A capital lease is more like a purchase or installment sale.
The lessee must record an asset and a long-term liability equal to the present value of the lease payments over the lease term.
Each lease payment consists of interest and repayment of debt.
Depreciation is computed on the asset.
A lease is recorded as follows:
Equipment Under Capital Lease ,740
Obligations Under Capital Lease 14,740
Record capital lease on machinery

79. Classifications with Long-Term Leases
Equipment Under Capital Lease is classified as a long-term asset.
Obligations Under Capital Lease are classified as a long-term liability.

80. Accounting for Long-Term Leases
Record depreciation as follows:
Depreciation Expense,
Equipment Under Capital Lease ,457
Accumulated Depreciation,
Equipment Under Capital Lease ,457
To record depreciation expense
on capital lease

81. Accounting for Long-Term Leases
Record depreciation as follows:
Depreciation Expense,
Equipment Under Capital Lease ,457
Accumulated Depreciation,
Equipment Under Capital Lease ,457
To record depreciation expense
on capital lease
Record a payment as follows:
Interest Expense 2,358
Obligations Under Capital Lease ,642
Cash ,000
Made payment on capital lease

82. Pensions
A pension plan is a contract between a company and its employees in which the company agrees to pay benefits to the employees after they retire.
Contributions from the employee and the company are paid into a pension fund.
Defined contribution plans require that the employer contribute an annual amount specified by an agreement between the company and its employees or a resolution of the board of directors.
Pensions are accounted for by a debit to Pension Expense and a credit to Cash or a liability.

83. Pensions (continued)
Defined benefit plans require that the employer’s annual contribution is the amount needed to fund pension liabilities arising from employment in the current year, but the exact amount will not be determined until the retirement and death of the current employees.
Accounting is complex, as discussed in FASB # 87.
The amount of pension expense must first be determined.
If the amount of cash contributed to the fund is less than the pension obligation, a balance sheet liability exists.

84. Other Postretirement Benefits
Postretirement benefits are in addition to pension benefits and include health care and other benefits.
In the past, they were accounted for on a cash basis.
The FASB has concluded that they should be estimated and accrued while the employee is working, in order to follow the matching principle.

85. OK, LET’S REVIEW . . .
1. Identify the management issues related to issuing long-term debt.
2. Identify and contrast the major characteristics of bonds.
3. Record the issuance of bonds at face value and at a discount or premium.
4. Use present values to determine the value of bonds.

86. CONTINUING OUR REVIEW . . .
5. Use the straight-line and effective interest methods to amortize (a) bond discounts and (b) bond premiums.
6. Account for bonds issued between interest dates and make year-end adjustments.

87. AND FINALLY . . .
7. Account for the retirement of bonds and the conversion of bonds into stock.
8. Explain the basic features of mortgages payable, installment notes payable, long-term leases, and pensions and other postretirement benefits as long-term liabilities.