1. Copyright © by Houghton Mifflin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College

2. Chapter 11 Long-Term Liabilities

3. Copyright © by Houghton Mifflin Company. All rights reserved.3 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 bond discounts and premiums.

4. Copyright © by Houghton Mifflin Company. All rights reserved.4 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. LEARNING OBJECTIVES (continued) LEARNING OBJECTIVES (continued)

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

6. Copyright © by Houghton Mifflin Company. All rights reserved.6 Long-Term Liabilities u Obligations of business that are due to be paid after one year or beyond the operating cycle, whichever is longer. u 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. u 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.

7. Copyright © by Houghton Mifflin Company. All rights reserved.7 u Growing businesses frequently need long-term financing to invest in R&D activities and long- term assets. u 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. u Related management issues: 1.Whether or not to have long-term debt. 2.How much long-term debt to have. 3.What types of long-term debt to have. Reasons and Resources for Long-Term Debt

8. Copyright © by Houghton Mifflin Company. All rights reserved.8 The Decision to Issue Long-Term Debt u A key management decision is whether to rely solely on stockholders’ equity or to rely partially on long-term debt for long-term funds. u Advantages of common stock over debt. 4 It does not have to be paid back. 4 Dividends are paid only if the company earns sufficient income. u Advantages of long-term debt over common stock. 4 Stockholder control – creditors do not elect directors. 4 Tax effects - interest is tax deductible. 4 Financial leverage – after interest is paid, all excess earnings accrue to stockholders.

9. Copyright © by Houghton Mifflin Company. All rights reserved.9 Average Debt to Equity for Selected Industries

10. Copyright © by Houghton Mifflin Company. All rights reserved.10 Disadvantages of Debt Financing u Cash is required to make periodic interest payments and to pay back the principal amount. u Company can become overcommited. u Financial leverage can work against a company if the earnings from its investments do not exceed its interest payments.

11. Copyright © by Houghton Mifflin Company. All rights reserved.11 How Much Debt u The use of debt financing varies widely across industries. u Failure to make timely payments could force a company into bankruptcy. u The interest coverage ratio (ICR) is a measure of how much risk a company is undertaking with its debt. u The ICR measures the degree of protection a company has from default on interest payments. ICR = Income Before Taxes + Interest Expense Interest Expense

12. Copyright © by Houghton Mifflin Company. All rights reserved.12 What Types of Long-Term Debt u Long-term bonds (debentures) have different characteristics. 4 Time until repayment. 4 Amount of interest. 4 Ability to repay early. 4 Conversion into other securities. u Other types of long-term debt. 4 Long-term notes. 4 Mortgages. 4 Long-term leases. u Long-term financing must be structured to the best advantage of the company.

13. Copyright © by Houghton Mifflin Company. All rights reserved.13Discussion Q. Q. What are the advantages and disadvantages of issuing long-term debt? A. A. Advantages of long-term debt are (1) common stockholders do not relinquish control, (2) interest on debt is tax deductible, and (3) financial leverage may increase a company’s earnings. Disadvantages of long-term debt are (1) interest and principal must be repaid on schedule, and (2) financial leverage can work against a company if a project is not successful.

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

15. Copyright © by Houghton Mifflin Company. All rights reserved.15 The Nature of Bonds u A bond is a security, usually long term, representing money borrowed from the investing public by a corporation or some other entity. u Bonds must be repaid at a specified time and require periodic (usually semiannual) payments of interest. u Bondholders are creditors. u Bonds are promises to repay the amount borrowed (principal) and interest at a specified rate on specified future dates.

16. Copyright © by Houghton Mifflin Company. All rights reserved.16 The Nature of Bonds (continued) bond certificate registration number u The bondholder receives a bond certificate or registration number as evidence of the organization's debt. bond issue u A bond issue is the total number of bonds issued at one time. bond indenture u A bond indenture defines the rights, privileges, and limitations of the bondholders. u The bond indenture describes the maturity date, interest payment dates, interest rate, and other characteristics of the bonds.

17. Copyright © by Houghton Mifflin Company. All rights reserved.17 The Nature of Bonds (continued) u The price of bonds is stated in terms of a percentage of face (or par) value. u A quote of 103 1/2 means the price is $1,035 per $1,000 bond. u When a bond is sold above 100, it sells at a premium. u When a bond is sold below 100, it sells at a discount.

18. Copyright © by Houghton Mifflin Company. All rights reserved.18 Bond Features u A bond indenture is written to fit the financing needs of a business. u Bonds may have several features. 4 Secured or unsecured. 4 Term or serial.

19. Copyright © by Houghton Mifflin Company. All rights reserved.19 Secured or Unsecured Bonds u Unsecured (debentures) u Unsecured (debentures) are issued based on the company’s credit rating. u Secured bonds u Secured bonds give bondholders a pledge of certain assets as a guarantee of repayment.

20. Copyright © by Houghton Mifflin Company. All rights reserved.20 Term or Serial Bonds u Term bonds u Term bonds all mature at the same time. u Serial bonds u Serial bonds mature on several different dates.

21. Copyright © by Houghton Mifflin Company. All rights reserved.21Discussion Q. Q. What are a bond certificate, a bond issue, and a bond indenture? A. A. A bond certificate is the document that gives evidence of a company’s debt to a bondholder. A bond issue is the total amount of bonds made available at one time. A bond indenture is the supplementary agreement that specifies the characteristics of the bond issue.

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

23. Copyright © by Houghton Mifflin Company. All rights reserved.23 Accounting for Bonds Payable u When the board of directors decides to issue bonds, it presents the proposal to the stockholders for approval. u Certificates and bond agreement are prepared. u When bonds are authorized, no journal entry is required. u Normally, a memorandum is prepared giving the particulars of the bond issue.

24. Copyright © by Houghton Mifflin Company. All rights reserved.24 Balance Sheet Disclosure of Bonds u Bonds are disclosed on the balance sheet in one of two ways: 1.Usually as long-term liabilities. 2.Possibly as current liabilities if maturity date is within one year.

25. Copyright © by Houghton Mifflin Company. All rights reserved.25 Important Provisions of the Bond Indenture u Important provisions of the bond indenture are reported in the notes to the financial statements. 4 List of bond issues. 4 Kinds of bonds. 4 Interest rates. 4 Any securities connected with the bonds. 4 Interest payment dates. 4 Maturity dates. 4 Effective interest rates.

26. Copyright © by Houghton Mifflin Company. All rights reserved.26 Bonds Issued at Face Value Jan. 1 Cash100,000 Bonds Payable 100,000 Sold $100,000 of 9%, 5-year bonds at 5-year bonds at face value, face value, interest paid Jan. 1 and July 1 interest paid Jan. 1 and July 1 July 1 Bond Interest Expense 4,500 Cash 4,500 Semiannual interest $100,000 x.09 x 6/12 year $100,000 x.09 x 6/12 year

27. Copyright © by Houghton Mifflin Company. All rights reserved.27 Face and Market Interest Rate u Face Interest Rate u Face Interest Rate – the rate of interest, on an annual basis, paid to bondholders, expressed as a percentage of the face value of the bond. u Market Interest Rate u Market Interest Rate – the rate of interest paid in the market on bonds of similar risk, also called effective interest rate. u DiscountsPremiums u Discounts or Premiums result from a difference between the Market Interest Rate on date of issue and the Face Interest Rate, established by the bond issuer prior to the date of issue.

28. Copyright © by Houghton Mifflin Company. All rights reserved.28 Jan. 1 Cash 96,149 Unamortized Bond Discount 3,851 Bonds Payable 100,000 Sold $100,000 of 9%, 5-year bonds at 96.149 9%, 5-year bonds at 96.149 Face amount of bonds$100,000 Face amount of bonds$100,000 Less purchase price 96,149 Less purchase price 96,149 Unamortized bond discount$ 3,851 Unamortized bond discount$ 3,851 Bonds Issued at a Discount

29. Copyright © by Houghton Mifflin Company. All rights reserved.29 Bonds Issued at a Premium Jan. 1 Cash104,100 Unamortized Bond Premium 4,100 Bonds Payable 100,000 Sold $100,000 of Sold $100,000 of 9%, 5-year bonds at 104.1 9%, 5-year bonds at 104.1 Purchase price$104,100 Purchase price$104,100 Less face amount 100,000 Less face amount 100,000 Unamortized premium$ 4,100 Unamortized premium$ 4,100

30. Copyright © by Houghton Mifflin Company. All rights reserved.30 Bond Issue Costs u Fees to underwriters. 4 Amortized over the life of the bonds in a separate account. u Bond issue costs decrease the amount of cash received. 4 Increase bond discount. 4 Decrease bond premium. u Bond issue costs can be spread over the life of the bonds through the amortization of a discount or premium.

31. Copyright © by Houghton Mifflin Company. All rights reserved.31Discussion Q. Q. Under what circumstance does a bond sell at face value? A. A. When the face interest rate of the bond is identical to the market interest for similar bonds on the date of issue.

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

33. Copyright © by Houghton Mifflin Company. All rights reserved.33 Using Present Value to Value a Bond u 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: 1.A series of fixed interest payments. 2.A single payment at maturity. u The amount of interest a bond pays is fixed over its life.

34. Copyright © by Houghton Mifflin Company. All rights reserved.34 u The market interest rate varies from day to day and therefore what investors are willing to pay changes as well. u If the current market interest rate is now greater than the bond’s interest rate, investors are willing to pay less. u If the current market interest rate is now less than the bond’s interest rate, investors are willing to pay more. Influence of the Market Interest Rate

35. Copyright © by Houghton Mifflin Company. All rights reserved.35Discussion Q. Q. A corporation sold $500,000 of 5%, $1,000 bonds on the interest payment date. What would the proceeds from the sale be if the bonds were issued at 95, at 100, and at 102? A. A. The proceeds from the sale of $500,000 in bonds at 95 would be $475,000; at 100, $500,000; and at 102, $510,000.

36. Copyright © by Houghton Mifflin Company. All rights reserved.36 Present Value of a Bond u For a bond with a face value of $10,000, paying $450 every 6 months (9% annual rate), due in 5 years, cash flows to bondholder are 9 payments of $450 every six months, followed by one payment of $10,450. u If the Market Rate is 14% on date of issue, use tables, calculator, or computer for number of periods = 10, i = 7%, to give present value of cash flows = $8,240.80. u If the Market Rate is 8% on date of issue, number of periods = 10, i = 4%, to give present value of cash flows = $10,409.95.

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

38. Copyright © by Houghton Mifflin Company. All rights reserved.38 u When a bond is sold at a discount, the discount affects interest expense in each year of the bond issue. u Discount should be amortized over the life of the issue. u Unamortized bond discount decreases gradually over time. u Carrying value = Face value – discount. u Carrying value increases gradually. u By maturity date: 4 The carrying value of the issue equals the face value amount of the bonds. 4 The unamortized bond discount is zero. Bond Discount Issues

39. Copyright © by Houghton Mifflin Company. All rights reserved.39 Calculation of Total Interest Cost u 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. 4 Total Interest Cost = Total Stated Interest + Bond Discount. 4 Actual Interest Expense = (Issue Price - Face Value) + Total Interest Payments.

40. Copyright © by Houghton Mifflin Company. All rights reserved.40 Calculation of Total Interest Cost (continued…) Cash to be paid to bondholders Face value at maturity$100,000 Interest payments 45,000 Total cash to be paid$145,000 Less cash received 96,149 Total interest cost$ 48,851 Or Interest Payments $45,000 Bond discount 3,851 Total interest cost $48,851

41. Copyright © by Houghton Mifflin Company. All rights reserved.41 Accounting for Total Interest Cost u Effective Interest Rate = Stated Rate + Discount. amortization of the bond discount. u 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. u The interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period. u Zero coupon bonds are issued by some companies and governmental units. 4 They do not require periodic interest payments. 4 They represent a promise to pay a fixed amount at the maturity date.

42. Copyright © by Houghton Mifflin Company. All rights reserved.42 Methods of Amortizing a Bond Discount u Straight-line method: only used when not significantly different from effective interest method. u Effective interest method: preferred by APB.

43. Copyright © by Houghton Mifflin Company. All rights reserved.43 Carrying Value and Interest Expense - Bonds Issued at a Discount

44. Copyright © by Houghton Mifflin Company. All rights reserved.44 Methods of Amortizing a Bond Discount Straight-Line Method: E qual amortization of bond discount over each accounting period. Bond Discount = $3,851 Number of interest periods = 10 Amortization of Bond Discount per Interest Period = $385 First, semiannual interest payment: July 1Bond Interest Expense 4,885 Unamortized Bond Discount 385 Cash 4,500 Paid semiannual interest to bondholders and amortized the discount on 9%, 5-year bonds.

45. Copyright © by Houghton Mifflin Company. All rights reserved.45 Methods of Amortizing a Bond Discount Effective Interest Method: A pply a constant rate of interest to the carrying value at the beginning of each accounting period. Face value of bond $10,000 Bond discount 3,851 Carrying value at beginning of first period: $96,149 Semiannual interest expense @ 5% $4,807 Cash paid to bondholder 4,500 Amortization of bond discount for first interest period: $307 Bond discount (at end of first period) $3,544($3,851 - $307) Carrying value at end of first period$96,456($10,000 - $3,544)

46. Copyright © by Houghton Mifflin Company. All rights reserved.46 Amortizing a Bond Premium u A bond premium represents an amount that bondholders will not receive at maturity. u The premium is a reduction, in advance, of the total interest paid on the bonds over the life of the bond issue.

47. Copyright © by Houghton Mifflin Company. All rights reserved.47 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) 45,000 Total cash to be paid $145,000 Less cash received 104,100 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.

48. Copyright © by Houghton Mifflin Company. All rights reserved.48 Straight-Line Method of Amortizing a Bond Premium u Bond premium is spread evenly over the life of the bond issue. 4 Bond Interest = Stated Interest - Premium. u Bond Interest Expense per period = Total Interest Cost ÷ Number of periods July 1 Bond Interest Expense 4,090 Unamortized Bond Premium 410 Cash 4,500 Paid semiannual interest and amortized premium on amortized premium on 9%, 5-year bonds 9%, 5-year bonds

49. Copyright © by Houghton Mifflin Company. All rights reserved.49 Effective Interest Method of Amortizing a Bond Premium u The interest expense decreases slightly each period because the amount of the bond premium amortized increases slightly each period. u Apply a constant interest rate to the carrying value at the beginning of each period. u July 1 Bond Interest Expense 4,164 Unamortized Bond Premium 336 Cash 4,500 Paid semiannual interest to bondholders and interest to bondholders and amortized premium on 9%, amortized premium on 9%, 5-year bonds 5-year bonds

50. Copyright © by Houghton Mifflin Company. All rights reserved.50 Carrying Value and Interest Expense - Bonds Issued at a Premium

51. Copyright © by Houghton Mifflin Company. All rights reserved.51Discussion Q. Q. Why is a bond discount considered a component of total interest cost? A. A. A bond discount represents the amount in excess of the issue price that must be paid by the corporation at the time of maturity.

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

53. Copyright © by Houghton Mifflin Company. All rights reserved.53 Sale of Bonds Between Interest Dates u Generally accepted method is to collect from investors the interest that would have accrued for the partial period preceding the issue date. u When the first interest period is completed, the corporation pays investors the interest for the entire period. u 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.

54. Copyright © by Houghton Mifflin Company. All rights reserved.54 Accounting for Sale of Bonds Between Interest Dates May 1 Cash103,000 Bond Interest Expense 3,000 Bonds Payable 100,000 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 4,500 Cash 4,500 Paid semiannual interest $100,000 x.09 x 6/12 = $4,500

55. Copyright © by Houghton Mifflin Company. All rights reserved.55 Effect on Bond Interest Expense When Bonds Are Issued Between Interest Dates

56. Copyright © by Houghton Mifflin Company. All rights reserved.56 u Assume fiscal year ends Sept. 30 Sept. 30 Bond Interest Expense 2,075.50 Unamortized Bond Premium 174.50 To record accrual of interest on Interest Payable 2,250.00 To record accrual of interest on 9% bonds payable for 3 months 9% bonds payable for 3 months and amortization of one half of the and amortization of one half of the premium for the second interest premium for the second interest payment period payment period Year-End Accrual for Bond Interest Expense

57. Copyright © by Houghton Mifflin Company. All rights reserved.57 u When the next interest payment date occurs: Jan. 1 Bond Interest Expense2,075.50 Interest Payable2,250.00 Unamortized Bond Premium 174.50 Cash 4,500.00 Paid semiannual interest including interest previously including interest previously accrued, and amortized the accrued, and amortized the premium for the period since premium for the period since the end of the fiscal year the end of the fiscal year

58. Copyright © by Houghton Mifflin Company. All rights reserved.58Discussion Q. Q. When bonds are issued between interest dates, why is it necessary for the issuer to collect an amount equal to accrued interest from the buyer? A. A. Because the full period’s interest is paid on interest dates to the holders on those dates, the interest must be allocated between the buyer and the seller when a sale takes place between interest dates. The buyer pays the seller the accrued interest for the period since the last interest date.

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

60. Copyright © by Houghton Mifflin Company. All rights reserved.60 Retirement of Bonds call price, u 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. callable bonds. u Such bonds are known as callable bonds. early extinguishment of debt. u The retirement of a bond issue before its maturity date is called early extinguishment of debt.

61. Copyright © by Houghton Mifflin Company. All rights reserved.61 u Retirement of Bonds (on an interest payment date) at 105, as stated in the bond indenture. July 1 Bonds Payable 100,000 Unamortized Bond Premium 1,447 Loss on Retirement of Bonds 3,553 Cash105,000 Retired 9% bonds at 105 Retired 9% bonds at 105 Accounting for Retirement of Bonds

62. Copyright © by Houghton Mifflin Company. All rights reserved.62 Conversion of Bonds into Common Stock u Convertible bonds u Convertible bonds can be exchanged for other securities of the corporation. u Convertibility enables an investor to make more money because if the market price of the common stock rises, the value of the bonds rises. u If the stock price does not rise, the investor still holds the bonds and receives both interest payments and principal at the maturity date.

63. Copyright © by Houghton Mifflin Company. All rights reserved.63 Reasons a Company Issues Convertible Bonds 1.Desirability of convertible bonds to investors enable companies to issue at lower interest rates – lower cost. 2.Management does not give up any control – bondholders have no voting rights. 3.Bond interest expense is tax deductible – tax savings. 4.If the company earns a return higher than the interest expense, income will increase. 5.Financial flexibility: If stock price increases and convertible bond price exceeds face value, management can avoid repaying bonds because bondholders will want to convert into common stock.

64. Copyright © by Houghton Mifflin Company. All rights reserved.64 Possible Disadvantages of Convertible Bonds 1.Bond interest payments must be made on stated dates (usually semiannually.) Failure to do so can lead to bankruptcy. 2.When bonds are converted, bondholders become stockholders with additional rights, e.g. voting rights. 3.Conversion to common stock dilutes existing stockholders’ ownership.

65. Copyright © by Houghton Mifflin Company. All rights reserved.65 July 1 Bonds Payable 100,000 Unamortized Bond Premium 1,447 Common Stock 32,000 Paid-in Capital in Excess of Par Value, Common 69,447 Converted 9% bonds payable into $8 par value common stock into $8 par value common stock at a rate of 40 shares for each at a rate of 40 shares for each $1,000 bond $1,000 bond Accounting for Conversion of Bonds into Common Stock

66. Copyright © by Houghton Mifflin Company. All rights reserved.66Discussion Q. Q. Why would a company want to exercise the callable provision of a bond when it can wait to pay off the debt? A. A. A company may have earned enough money to pay off the debt; the reason for the debt may no longer exist; market conditions may have changed, making it cost-effective to call the debt; or the company may want to restructure its debt to equity ratio.

67. 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. Other Long-Term Liabilities

68. Copyright © by Houghton Mifflin Company. All rights reserved.68 Mortgages Payable mortgage u A mortgage is a long-term debt secured by real property, usually paid in equal monthly installments. July 1 Mortgage Payable300 Mortgage Interest Expense500 Cash800 Made monthly mortgage payment payment

69. Copyright © by Houghton Mifflin Company. All rights reserved.69 Installment Notes Payable u Installment notes payable occur when the terms of a note call for a series of periodic payments. u Each payment includes the interest to date plus a repayment of part of the amount that was borrowed. u On 12/31/x1, $100,000 is borrowed on a 15%, 5-year installment note. 12/31/x1Cash 100,000 Notes Payable 100,000 Borrowed $100,000 Borrowed $100,000 at 15% on a 5-year at 15% on a 5-year installment note installment note

70. Copyright © by Houghton Mifflin Company. All rights reserved.70 12/31/x2 Notes Payable20,000 Interest Expense15,000 Cash 35,000 Made first installment payment on note payment on note $100,000 x.15 = $15,000 $100,000 x.15 = $15,000 12/31/x3 Notes Payable20,000 Interest Expense12,000 Cash 32,000 Made second installment payment on note payment on note $80,000 x.15 = $12,000 $80,000 x.15 = $12,000 Payments of Accrued Interest Plus Equal Amounts of Principal

71. Copyright © by Houghton Mifflin Company. All rights reserved.71 12/31/x2 Notes Payable14,833 Interest Expense15,000 Cash 29,833 Made first installment Made first installment payment on note payment on note 12/31/x3 Notes Payable17,058 Interest Expense12,775 Cash 29,833 Made second installment payment on note payment on note Payments of Accrued Interest Plus Increasing Amounts of Principal

72. Copyright © by Houghton Mifflin Company. All rights reserved.72 Long-Term Leases u There are several ways for a company to obtain new operating assets. 1. Borrow money and buy the asset. 4 Asset and liability are recorded at the amount paid. 4 Asset is subject to periodic depreciation. 2. Rent the asset on a short-term lease. 4 Operating lease. 4 Risks of ownership remain with the lessor. 3. Obtain the asset on a long-term lease. 4 Requires no immediate cash payment. 4 Cost is less than a short-term lease.

73. Copyright © by Houghton Mifflin Company. All rights reserved.73 u Often the lease cannot be canceled. u Duration of the lease may be about the same as the useful life of the asset. u There may be a provision for the lessee to buy the asset at the end of the lease term. u Similar to an installment purchase. If a lease meets the above conditions, the FASB rules that it should be accounted for as a Capital Lease. Related Accounting Issues for Long-Term Leases

74. Copyright © by Houghton Mifflin Company. All rights reserved.74 u A capital lease is more like a purchase or installment sale. u The lessee must record an asset and a long-term liability equal to the present value of the lease payments over the lease term. u Each lease payment consists of interest and repayment of debt. u Depreciation is computed on the asset. u A lease is recorded as follows: Equipment Under Capital Lease 14,740 Obligations Under Capital Lease 14,740 Record capital lease on machinery Capital Leases

75. Copyright © by Houghton Mifflin Company. All rights reserved.75 u Equipment Under Capital Lease is classified as a long-term asset. u Obligations Under Capital Lease is classified as a long-term liability. Capital Leases (continued…)

76. Copyright © by Houghton Mifflin Company. All rights reserved.76 u Record depreciation as follows: Depreciation Expense, Equipment Under Capital Lease 2,457 Accumulated Depreciation, Equipment Under Capital Lease 2,457 To record depreciation expense on capital lease on capital lease u Record a payment as follows: Interest Expense 2,358 Obligations Under Capital Lease 1,642 Cash 4,000 Made payment on capital lease Made payment on capital lease Accounting for Long-Term Leases

77. Copyright © by Houghton Mifflin Company. All rights reserved.77Pensions pension plan u 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. pension fund u Contributions from the employee and the company are paid into a pension fund. u Defined contribution plans u 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. u Pensions are accounted for by a debit to Pension Expense and a credit to Cash or a liability.

78. Copyright © by Houghton Mifflin Company. All rights reserved.78 u Defined benefit plans u 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. u Accounting is complex, as discussed in FASB # 87. u The amount of pension expense must first be determined. u If the amount of cash contributed to the fund is less than the pension obligation, a balance sheet liability exists. Pensions (continued)

79. Copyright © by Houghton Mifflin Company. All rights reserved.79 u Postretirement benefits are in addition to pension benefits and include health care and other benefits. u In the past, they were accounted for on a cash basis. u The FASB has concluded that they should be estimated and accrued while the employee is working, in order to follow the matching principle. Other Postretirement Benefits

80. Copyright © by Houghton Mifflin Company. All rights reserved.80Discussion Q. Q. What is a pension plan? What assumptions must be made to account for the expenses of such a plan? A. A. 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. Among the assumptions that must be made to determine the costs of a pension plan are the average remaining service life of active employees, the expected return on pension plan assets, and expected future salary increases.

81. Copyright © by Houghton Mifflin Company. All rights reserved.81 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. OK, LET’S REVIEW...

82. Copyright © by Houghton Mifflin Company. All rights reserved.82 5.Use the straight-line and effective interest methods to amortize bond discounts and bond premiums. 6.Account for bonds issued between interest dates and make year-end adjustments. CONTINUING OUR REVIEW...

83. Copyright © by Houghton Mifflin Company. All rights reserved.83 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. AND FINALLY...