Chapter Thirteen
Accounting for Long-term
Liabilities: Bonds and Notes
Payable
Long-term Liabilities
Learning Objectives
1.
Understand the characteristics and advantages of LTD
2.
Price a bond issuance
3.
Account for bond interest and amortization of
premiums & discounts
4.
Account for bond redemptions and determine gains
and losses
5.
Impute interest on notes
6.
Financial statement analysis for long-term liabilities
7.
Cash flow effects
2
Sources of Financing: Debt
Versus Equity
Debt:
„ Interest paid is taxdeductible
„ Debt does not carry voting
rights
„ Negatively affects debt-toequity ratio
„ Increases risk (potential
default and interest rate
changes)
Equity:
Dividends paid on stock
are not tax-deductible
„ Issuance of stock
reduces current
stockholders’ control
„ Negatively affects EPS
„
3
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Definition of Liabilities
„
Current Definition:
Probable future sacrifices of economic
benefits arising from present obligations to
transfer assets or provide services in the
future as a result of past transactions or
events
4
Definition of Liabilities-Proposed
Amendment
Proposed FASB Addition:
„
Certain obligations, primarily financial
instruments or components of compound
financial instruments, require or permit
settlement by issuance of equity shares. If those
components establish a relationship between
the issuer and the holder that is not an
ownership relationship, they are liabilities.
5
Is It Debt or Equity?
„
SFAS No. 150 clarifies that the following
instruments should be treated as liabilities:
1.
2.
3.
Issued with mandatory redemption feature
Includes an obligation to repurchase shares of stock
or requires transfer of assets
Embodies an unconditional obligation that the issuer
must issue equity shares if the value of the
obligation is fixed
6
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Bonds
„
Contractual borrowing agreement in which the
issuing party agrees to pay the investor interest
at a specified rate and agrees to repay the
amount borrowed at a specified maturity date
„
„
The loan amount is often called the face value,
or par value, of the bond
Most bonds are issued in denominations of
$1,000 and pay interest semiannually
7
Bond Contract Terms
„
„
„
„
Debenture bonds—not backed by specific collateral but
based on the general creditworthiness of the firm
(unsecured bonds)
Mortgage bonds—backed by specific collateral like real
estate (secured bonds)
Coupon bonds—bear a coupon for each interest
payment; coupons can be transferred between parties
without notifying the issuer
Zero-coupon bonds—do not require periodic interest
payments, but instead promise to pay a fixed amount at
maturity
8
More Bond Contract Terms
„
„
„
„
Convertible bonds—may be converted into stock
by the holder at a specified conversion rate
Callable bonds—can be retired by the issuer for
a specified price before their maturity date
Serial bonds—issued on the same date that
have differing maturity dates
Bond covenants—restrictions on the issuer used
to provide additional safety for the bondholders
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Characteristics of a Bond
„
Bond prices are stated as a percentage of face
value (Bonds selling at 102 means that the bond
is selling at 102 percent of face value)
„
Face or Stated or Coupon interest rate is the rate
of interest to be paid at each interest period
„
Market or Effective interest rate is the rate
demanded by the bond market at a particular time
for similar bonds, it determines the interest
expense each period
10
Determining a Bond’s Selling Price
„
„
Illustration: Assume that Charger Company issues
bonds with a face value of $200,000 that pay 10 percent
interest semiannually and mature in five years. The
market interest rate at issuance is 8 percent.
Calculate the bond issue price using a calculator:
Future Value = $200,000
Payments = $10,000
Present value = $????
N = 10
I = 4%
11
Premiums and Discounts
Premiums:
„ When the stated
interest rate exceeds
the market interest
rate, bonds will sell at
a premium.
Discounts:
„ When the market
interest rate exceeds
the stated interest
rate, bonds will sell at
a discount.
12
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Recording Bond Issuance
„
„
Illustration: Recall that Charger Co. issued bonds with a
face value of $200,000 that pay 10 percent interest
semiannually and mature in five years. The market
interest rate at issuance was 8 percent. As computed
earlier, the issue price is $216,222 and the premium is
$16,222.
Record the issuance of bonds:
13
Recording Discounts on Bonds
„
„
If issue price is less than face value, bonds will
sell at a discount.
To record the issuance of a bond at a discount:
Cash
Discount on Bonds
Bonds Payable
„
xxx
xxx
xxx
Discount on Bonds is presented on the balance
sheet as a reduction to the Bonds Payable
amount.
14
Recording Bonds Issued Between
Interest Payment Dates
„
„
Illustration: On 3/1/05, Wildcat Co. issues, at 103 plus
accrued interest, 10-year bonds with a face value of
$100,000 and a stated interest rate of 6%. Interest is
paid on June 30 and December 31. Bonds are dated
1/1/05, and will be due on 1/1/15.
Calculate the accrued interest at time of issuance:
$100,000 x 6% x 2/12 = $1,000
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Recording Bonds Issued Between
Interest Payment Dates
• Record the issuance of bonds:
Cash
Interest Expense
Premium on Bonds
Bonds Payable
104,000
1,000
3,000
100,000
16
Bond Issue Costs
Bond issue costs
should be treated
as a deferred
charge and
amortized over the
life of the bonds.
• Legal fees
• Transfer fees
• Brokerage
costs
• Taxes
17
Recording Bond Issue Costs
„
Illustration: Assume that a company issues bonds with
a $100,000 face value at 100 and must pay $5,000 of
costs associated with the issuance. The bond life is 5
years and the company uses a straight-line method to
amortize bond issue costs.
Cash
Bond Issue Costs
Bonds Payable
95,000
5,000
100,000
18
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Recording Bond Issue Costs
• To record the amortization of the bond issue costs each
period:
Bond Issue Expense
Bond Issue Costs
500
500
19
Amortizing a Bond Premium or Discount
Amortizing a bond premium or discount involves
adjusting the Interest Expense account
„
Premium: as the
unamortized premium
decreases, the
carrying value of the
bond decreases.
„
Discount: as the
unamortized discount
decreases, the
carrying value of the
bond increases.
20
Amortizing a Bond Premium: StraightLine Method
„
Illustration: Recall that Charger Co. issued bonds with a
face value of $200,000 that pay 10 percent interest
semiannually and mature in five years. The market interest
rate at issuance was 8 percent. As computed earlier, the
issue price is $216,222 and the premium is $16,222.
„
Record the interest entry as follows:
Interest Expense
Premium on Bonds ($16,222 ÷ 10 periods)
Cash
8,378
1,622
10,000
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Effective Interest Method
„
„
„
Alternative to the straight-line method of
amortization in which the same dollar amount of
interest expense is reported each period
The effective interest method amortizes a
premium or discount at a constant rate of
interest over the life of the bond
The amount amortized differs in each period.
22
Amortization Schedule Using the Effective
Interest Method (page 600)
23
Redemption of Bonds – Gains/Losses
„
„
If bonds reach their maturity date and principal is
repaid, no gain/loss is usually recognized.
If bonds are retired before their maturity date,
calculate the gain/loss as follows:
Gain/Loss =
[Bond Carrying Value–Unamortized Bond Issue Costs] - Bond Call
Price
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Calculating a Loss on a Bond Retirement
Bruin Co. issued bonds on 1/1/05 that
mature on 12/31/09. The bonds had a face
value of $200,000 and pay 10 percent
interest semiannually. The market rate at
issuance was 12 percent. The issue price
was $185,280 and the bond issue costs
were $5,000. Use effective interest amort.
„ Assume that on 1/1/06, Bruin Co. retires
the bonds at 102. What is the gain or loss?
„
25
Calculating a Loss on a Bond Retirement
26
Accrued Interest When Retiring
Bonds
„
1.
2.
3.
4.
Illustration: Assume that Bruin Co. retired its bonds on
3/1/06, instead of on the interest payment date of
1/1/06.
Base the gain or loss on the bond carrying value as of
the date of redemption.
Any premium or discount must be amortized up to the
date of redemption.
If bond issue costs are involved, they must also be
amortized up to the redemption date.
The issuer must typically pay the call price of the bond
plus the accrued interest at the time of redemption.
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Reporting a Gain or Loss on
Bond Redemption
„
Most companies will present gains or losses
on bond redemptions in the other income or
expense section of the income statement
28
Long-Term Notes Payable
„
„
Written promissory
agreements to pay a
set amount at some
future date
Also require the
payment of explicit
interest in addition to
the base obligation
amount
„
Note: The accounting
issues for notes
payable are similar to
those for bonds
payable. Many
companies do not
distinguish between
the two on their
financial statements.
29
Imputed Interest Rate
„
If the interest rate on a bond is not readily
available or the stated rate is
unrealistically low, an imputed interest rate
is used.
Imputed
Interest
Rate
An estimated rate based on the
rate that an independent
borrower and an independent
lender would negotiate for a
similar transaction under
comparable terms and
conditions
30
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Valuing a Non-Interest-Bearing Note
„
Illustration: Assume that on 1/1/05, Buy Co.
purchases a depreciable asset from Sell Co. in
exchange for a five-year non-interest-bearing note:
Principal of $100,000 is due on 1/1/10. An imputed
interest rate of 8 percent is assumed.
„
First compute the present value of the note using a
calculator (Future Value = $100,000, N = 5, I = 8%):
31
Valuing a Non-Interest-Bearing Note
„ The
difference between the present
value of the note and the face value is
a discount on notes payable:
32
Amortizing the
Discount on Notes Payable
„
Illustration: Recall that Buy Co. recorded a Discount on
Notes Payable of $31,942 on 1/1/05. At each year end,
the company should record an adjusting entry to
amortize the Discount on Notes Payable account and
recognize interest expense. Buy uses the effective
interest method and prepares an appropriate
amortization schedule. Based on that schedule, the
following entry should be recorded on 12/31/05:
Interest Expense
Discount on Notes Payable
5,445
5,445
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Debt-to-Equity Ratio
Indicates the percentage of total assets that is
financed by creditors
Total Debt ÷ Total Assets
34
Return on Stockholders’ Equity (ROE)
Shows how efficiently a company uses
stockholders’ investments to produce income
Return on Stockholders’ Equity (ROE) =
Net Income ÷ Average Total Stockholders’ Equity
35
Return on Assets
„
Shows how efficiently a company uses its
assets to produce income
Return on Assets (ROA) =
Net Income ÷ Average Total Assets
36
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Interest Coverage
Measures a company’s ability to meet its interest
payments as they come due
Times Interest Earned =
Income Before Interest and Taxes
÷ Interest Expense
37
Cash Flows and Long-Term Debt
„
Cash flows from long-term debt are presented in
the financing section of the statement of cash
flows
Georgia-Pacific
Excerpt from Statement of Cash Flows (in millions)
Dec. 31, 2003
Financing Activities:
Repayments and maturities of long-term debt
(8,090)
Additions to long-term debt
7,165
Fees paid to issue debt
(55)
Decrease in bank overdrafts
(45)
Decrease in accounts receivable secured borrowings and
short-term notes
(21)
Proceeds from option plan exercises
18
Employee stock purchase plan
23
Cash dividends paid
(126)
Cash used for financing activities
(1,131)
38
Cash Flows and Interest Expense
Remember that the amount of interest
expense reflected on the income
statement is based on accrual accounting.
„ How can we find the amount of actual
cash paid for interest?
„ Begin with the interest expense amount
and adjust with the change in all balance
sheet accounts related to interest
„
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Cash Flows and Interest Expense:
Illustrated
Iverson Co. shows interest expense for 2005 of $100,000
on its income statement. Interest-related balance sheet
accounts follow:
Beg. Bal. End. Bal.
Interest Payable
$20,000
$35,000
Discount on Bonds
40,000
30,000
To compute the actual cash paid for interest:
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