1. 1 Long-Term Liabilities Chapter 15 ACCT 202 WEEK 4 ACCT 202 WEEK 4

2. 2 Bonds: An Introduction A bond is an interest bearing long- term note payable. Bonds are groups of notes payable issued to multiple lenders called bondholders. –principal –interest rate –interest payment dates

3. 3 Types of Bonds Term bonds Serial bonds Secured or mortgage bonds Debenture bonds

4. 4 Bond Prices A bond is quoted as a percent of its face value. A quote of 99½ means that a $1,000 bond sells for $1,000 × 0.995, or $995. Bond prices are affected by... –time to maturity. –credit rating of issuer. –interest rate.

5. 5 Present Value The amount invested today receives a greater amount at a future date which is called the present value of a future amount. It depends upon... –the amount of the future receipt. –the length of time to the future receipt. –interest rate for the period.

6. 6 Issuing Bonds Payable to Borrow Money 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

7. 7 Issuing Bonds Payable to Borrow Money What is the entry for the interest payment of July 1? $1,000,000 × 10% × 1/2 = $50,000 July 1 Interest Expense50,000 Cash50,000 To record semiannual interest

8. 8 Issuing Bonds and Notes Payable Between Interest Dates 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

9. 9 Issuing Bonds and Notes Payable Between Interest Dates What is the July 1 interest expense? $1,000,000 × 10% × 1/4 = $25,000 June 30 Interest Expense25,000 Interest Payable25,000 Cash50,000 To pay semiannual interest

10. 10 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 Issuing Bonds Payable at a Discount

11. 11 Account for bonds payable Transactions. Objective 1

12. 12 Straight-Line Amortization of Bond Discount This method amortizes the bond discount by dividing it into equal amounts for each interest period. Granite Corp. would amortize the $7,500 discount over 20 periods. $7,500 ÷ 20 = $375 per period

13. 13 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

14. 14 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 Issuing Bonds Payable at a Premium

15. 15 Issuing Bonds Payable at a Premium 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

16. 16 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

17. 17 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 Reporting Bonds Payable

18. 18 Adjusting Entries for Interest Expense San Antonio Corporation issued $150,000 of its 8%, 10-year bonds at a $3,000 discount on October 1, 2002. The interest payments occur on March 31 and September 30 each year. San Antonio closes its books on December 31. What accounts are involved?

19. 19 Adjusting Entries for Interest Expense Interest Payable: $150,000 × 8% × 3/12 = $3,000 Discount Amortization: $3,000 ÷ 10 × 3/12 = $75 Interest Expense: $3,000 + $75 = $3,075 What is the adjusting entry?

20. 20 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 What is the entry on March 31, 2003?

21. 21 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

22. 22 Measure interest expense by the effective-interest method. Objective 2

23. 23 Effective-Interest Method of Amortization The effective-interest method keeps interest expense at the same percentage over any bond’s life. Generally accepted accounting principles require that interest expense be measured using the effective- interest method.

24. 24 Effective-Interest Method: Bond Discount 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%. These bonds mature in five years and pay interest semiannually.

25. 25 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

26. 26 Effective-Interest Method: Bond Discount What is the interest expense at the end of period one? $96,149 × 10% × 6/12 = $4,807 What is the interest payment at the end of period one? $100,000 × 9% × 6/12 = $4,500 $4,807 – $4,500 = $307 amortization

27. 27 Effective-Interest Method: Bond Discount End ofCarrying InterestCash Period ValueExpensePaid Amortization Issue 96,149 Date 1 96,456 4,8074,500307 2 96,779 4,8234,500323 3 97,118 4,8394,500339 4 97,474 4,8564,500356

28. 28 Effective-Interest Method: Bond Premium Assume the Granite Corp. issues a $100,000, 5-year, 9% bond to yield 8%, at a premium of $4,100. The first period interest expense is computed as follows: $104,100 × 8% × 6/12 = $4,164

29. 29 Effective-Interest Method: Bond Premium End ofCarrying InterestCash Period ValueExpensePaid Amortization Issue104,100 Date 1103,764 4,1644,500336 2103,415 4,1514,500349 3103,052 4,1374,500363 4102,674 4,1224,500378

30. 30 Account for retirement and conversion of bonds payable. Objective 3

31. 31 Retirement of Bonds Payable To retire a bond early, the issuer can... –purchase the bonds in the open market, or –exercise a call option. 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. The journal entry is the same in either case.

32. 32 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 Gain on Retirement of Bonds 22,000 Retired bonds payable

33. 33 Convertible Bonds and Notes Convertible bonds and notes give the holder the option of exchanging the bond for a specified number of shares of common stock. 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.

34. 34 Current Portion of Long- Term Debt Serial bonds and serial notes are payable in installments. The portion payable within one year is a current liability. The remaining debt is long term.

35. 35 Report Liabilities on the Balance Sheet Objective 4

36. 36 Report Liabilities on the Balance Sheet Notes payable and bonds payables are reported as liabilities on the balance sheet as either current or long-term. Current Liabilities: Notes payable, current………$200,000 Long-term Liabilities Notes payable, long-term…… $300,000

37. 37 Show the advantages and disadvantages of borrowing. Objective 5

38. 38 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. Issuing Bonds versus Stock Issuing Bonds versus Stock

39. 39 Advantage of Issuing Bonds versus Stock Example Suppose that Granite Corp., with net income of $300,000 and with 100,000 shares of common stock outstanding, needs $500,000 for expansion. Money can be borrowed at 10% interest. The income tax rate is 40%.

40. 40 Advantage of Issuing Bonds versus Stock Example 50,000 shares of common stock can be issued for $500,000. Management believes that the new cash can be invested in operations to earn income of $200,000 before interest and taxes. Should the company borrow the money or issue additional common stock?

41. 41 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

42. 42 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

43. 43 Advantage of Issuing Bonds versus Stock Example 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

44. 44 Bonds that give bondholders the right to take specified assets of the issuer if the issuer fails to pay principal or interest are called Debenture bonds Serial bonds Secured bonds Term bonds Revısıon questıons

45. 45 Answer: 3

46. 46 Bonds that mature at a single specified future date are called Debenture bonds Serial bonds Secured bonds Term bonds

47. 47 Answer: 4

48. 48 A $1,000 face value bond with a quoted price of 97 would sell for $97 $300 $970 $1,000

49. 49 Answer: $970 ($1,000 x.97)

50. 50 If the market interest rate is greater than the stated interest rate, bonds will sell at face value. a discount. a premium.

51. 51 Answer: 2 Investors demand a higher return than what the company is paying. They would pay less than the face amount (discount) in order to effectively earn the market rate of interest.

52. 52 If the market interest rate is 8%, a $1,000, 10%, 10-year bond, that pays interest semiannually would sell for less than face value. equal to face value. greater than face value. cannot be determined.

53. 53 Answer: 3 The bond would sell at a premium (greater than face value) because investors would be willing to pay more in order to receive the higher interest payments.

54. 54 What kind of account is Discount on Bonds Payable? Asset Contra asset Contra liability Stockholder’s equity

55. 55 Answer: 3

56. 56 The ledger of Gant Company shows Bonds Payable of $100,000 and Premium on Bonds Payable of $10,000. What is the amount of the carrying value of the bonds on the balance sheet?

57. 57 Answer: $110,000 Bonds Payable$100,000 Premium on bonds payable 10,000 $110,000

58. 58 Corey Company issues $100,000, 10-year bonds payable for cash of $94,000. The stated rate of interest is 10% and is paid semiannually. Corey uses the straight-line method to amortize bond discounts or premiums. How much interest expense will Corey recognize every 6 months?

59. 59 Answer: $5,300 Cash interest payment = $100,000 x.10 x ½ =$5,000 Bond discount amortization = $6,000 ÷ 20 interest payment periods = 300 Interest Expense$5,300

60. 60 If bonds with a face value of $100,000 and a carrying value of $80,000 are retired by paying cash of $75,000, the entry to record the sale would include Credit to Discount on Bonds Payable Credit to Premium on Bonds Payable Debit to Gain on Retirement of Bonds Debit to Retained Earnings

61. 61 Answer: 1 The entire entry would be: Bonds payable100,000 Discount on bonds payable 20,000 Cash 75,000 Gain on retirement of bonds 5,000

62. 62 Jennings Corp. has $10,000 of convertible bonds payable outstanding, with a bond premium of $2,000 also on the books. The bondholders convert the bonds into stock. The bonds may be converted into 4,000 shares of Jennings $1 par common stock. The journal entry to record the conversion would include: Credit Paid in Capital in Excess of Par Credit Premium on Bonds Payable Debit Loss on Conversion of Bonds Debit Treasury Stock

63. 63 Answer: 1 The journal entry would be: Bonds Payable10,000 Premium on Bonds Payable 2,000 Common stock4,000 Paid in Capital in Excess of Par 8,000