Chapter
15
Long-Term Liabilities
Chapter
15-1
Accounting Principles, Ninth Edition
Study Objectives
1.
Explain why bonds are issued.
2.
Prepare the entries for the issuance of bonds and
interest expense.
3.
Describe the entries when bonds are redeemed or
converted.
4.
Describe the accounting for long-term notes payable.
5.
Contrast the accounting for operating and capital leases.
6.
Identify the methods for the presentation and analysis
of long-term liabilities.
Chapter
15-2
Long-Term Liabilities
Bonds Basics
Bond Issues
Types of
bonds
Issuing bonds
at face value
Issuing
procedures
Discount or
premium
Trading
Issuing bonds
at a discount
Market value
Issuing bonds
at a premium
Chapter
15-3
Bond
Retirements
Redeeming
bonds at
maturity
Redeeming
bonds before
maturity
Converting
bonds into
common
stock
Other LongTerm
Liabilities
Long-term
notes payable
Lease
liabilities
Statement
Presentation
and Analysis
Presentation
Analysis
Bond Basics
Bonds are a form of interest-bearing notes
payable.
Three advantages over common stock:
1.
Stockholder control is not affected.
2. Tax savings result.
3. Earnings per share may be higher.
Chapter
15-4
SO 1 Explain why bonds are issued.
Bond Basics
Effects on earnings per share—stocks vs. bonds.
Illustration 15-2
Chapter
15-5
SO 1 Explain why bonds are issued.
Bond Basics
Question
The major disadvantages resulting from the use of
bonds are:
a. that interest is not tax deductible and the
principal must be repaid.
b. that the principal is tax deductible and interest
must be paid.
c. that neither interest nor principal is tax
deductible.
d. that interest must be paid and principal repaid.
Chapter
15-6
SO 1 Explain why bonds are issued.
Bond Basics
Types of Bonds
Secured and Unsecured (debenture) bonds.
Term and Serial bonds.
Registered and Bearer (or coupon) bonds.
Convertible and Callable bonds.
Chapter
15-7
SO 1 Explain why bonds are issued.
Bond Basics
Issuing Procedures
Bond contract known as a bond indenture.
Represents a promise to pay:
(1) sum of money at designated maturity date, plus
(2) periodic interest at a contractual (stated) rate on
the maturity amount (face value).
Paper certificate, typically a $1,000 face value.
Interest payments usually made semiannually.
Generally issued when the amount of capital needed is too
large for one lender to supply.
Chapter
15-8
SO 1 Explain why bonds are issued.
Bond Basics
Issuer of
Bonds
Illustration 15-3
Maturity
Date
Contractual
Interest
Rate
Chapter
15-9
Face or
Par Value
SO 1 Explain why bonds are issued.
Bond Basics
Bond Trading
Bonds traded on national securities exchanges.
Newspapers and the financial press publish bond prices
and trading activity daily.
Read as: Outstanding 5.125%, $1,000 bonds that mature in
2011. Currently yield a 5.747% return. On this day,
$33,965,000 of these bonds were traded. Closing price was
96.595% of face value, or $965.95.
Chapter
15-10
SO 1 Explain why bonds are issued.
Bond Basics
Determining the Market Value of Bonds
Market value is a function of the three factors that
determine present value:
1. the dollar amounts to be received,
2. the length of time until the amounts are received, and
3. the market rate of interest.
The features of a bond (callable, convertible, and so
on) affect the market rate of the bond.
Chapter
15-11
SO 1 Explain why bonds are issued.
Accounting for Bond Issues
Assume Contractual Rate of 8%
Chapter
15-12
Market Interest
Bonds Sold At
6%
Premium
8%
Face Value
10%
Discount
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Accounting for Bond Issues
Question
The rate of interest investors demand for loaning
funds to a corporation is the:
a. contractual interest rate.
b. face value rate.
c. market interest rate.
d. stated interest rate.
Chapter
15-13
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Accounting for Bond Issues
Question
Karson Inc. issues 10-year bonds with a maturity value of
$200,000. If the bonds are issued at a premium, this
indicates that:
a. the contractual interest rate exceeds the market
interest rate.
b. the market interest rate exceeds the contractual
interest rate.
c. the contractual interest rate and the market
interest rate are the same.
d. no relationship exists between the two rates.
Chapter
15-14
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at Face Value
Illustration: On January 1, 2010, Candlestick
Corporation issues $100,000, five-year, 10% bonds at
100 (100% of face value). The entry to record the sale
is:
Jan. 1
Cash
Bonds payable
Chapter
15-15
100,000
100,000
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at Face Value
Illustration: On January 1, 2010, Candlestick
Corporation issues $100,000, five-year, 10% bonds at
100 (100% of face value). Assume that interest is
payable semiannually on January 1 and July 1. Prepare
the entry to record the payment of interest on July 1,
2010, assume no previous accrual.
July 1
Bond interest expense
Cash
Chapter
15-16
5,000
5,000
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at Face Value
Illustration: On January 1, 2010, Candlestick
Corporation issues $100,000, five-year, 10% bonds at
100 (100% of face value). Assume that interest is
payable semiannually on January 1 and July 1. Prepare
the entry to record the accrual of interest on
December 31, 2010, assume no previous accrual.
Dec. 31
Bond interest expense
Bond interest payable
Chapter
15-17
5,000
5,000
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Discount
Illustration: On January 1, 2010, Candlestick, Inc. sells
$100,000, five-year, 10% bonds for $92,639 (92.639%
of face value). Interest is payable on July 1 and
January 1. The entry to record the issuance is:
Jan. 1
Cash
Discount on bonds payable
Bond payable
Chapter
15-18
92,639
7,361
100,000
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Discount
Statement Presentation
Illustration 15-6
Chapter
15-19
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Discount
Total Cost of Borrowing
Illustration 15-7
Illustration 15-8
Chapter
15-20
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Discount
Question
Discount on Bonds Payable:
a. has a credit balance.
b. is a contra account.
c. is added to bonds payable on the balance sheet.
d. increases over the term of the bonds.
Chapter
15-21
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Premium
Illustration: On January 1, 2010, Candlestick, Inc. sells
$100,000, five-year, 10% bonds for $108,111 (108.111%
of face value). Interest is payable on July 1 and
January 1. The entry to record the issuance is:
Jan. 1
Cash
Bonds payable
Premium on bond payable
Chapter
15-22
108,111
100,000
8,111
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Premium
Statement Presentation
Illustration 15-9
Issuing bonds at an amount different from face value is
quite common. By the time a company prints the bond
certificates and markets the bonds, it will be a coincidence
if the market rate and the contractual rate are the same.
Chapter
15-23
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Issuing Bonds at a Premium
Total Cost of Borrowing
Illustration 15-10
Illustration 15-11
Chapter
15-24
SO 2 Prepare the entries for the issuance of bonds and interest expense.
Accounting for Bond Retirements
Redeeming Bonds at Maturity
Assuming that the company pays and records separately
the interest for the last interest period, Candlestick
records the redemption of its bonds at maturity as
follows:
Bond payable
Cash
Chapter
15-25
100,000
100,000
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Bond Retirements
Redeeming Bonds before Maturity
When a company retires bonds before maturity, it is
necessary to:
1. eliminate the carrying value of the bonds at the
redemption date;
2. record the cash paid; and
3. recognize the gain or loss on redemption.
The carrying value of the bonds is the face value of the bonds
less unamortized bond discount or plus unamortized bond premium
at the redemption date.
Chapter
15-26
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Bond Retirements
Question
When bonds are redeemed before maturity, the gain
or loss on redemption is the difference between the
cash paid and the:
a. carrying value of the bonds.
b. face value of the bonds.
c. original selling price of the bonds.
d. maturity value of the bonds.
Chapter
15-27
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Bond Retirements
Illustration: Assume Candlestick, Inc. has sold its bonds at a
premium. At the end of the eighth period, Candlestick
retires these bonds at 103 after paying the semiannual
interest. The carrying value of the bonds at the redemption
date is $101,623. Candlestick makes the following entry to
record the redemption at the end of the eighth interest
period (January 1, 2014):
Bonds payable
Premium on bonds payable
1,623
Loss on redemption
1,377
Cash
Chapter
15-28
100,000
103,000
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Bond Retirements
Converting Bonds into Common Stock
Until conversion, the bondholder receives interest on the
bond.
For the issuer, the bonds sell at a higher price and pay a
lower rate of interest than comparable debt securities
without the conversion option.
Upon conversion, the company transfers the carrying value
of the bonds to paid-in capital accounts. No gain or loss is
recognized.
Chapter
15-29
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Bond Retirements
Illustration: Assume that on July 1 Saunders
Associates converts $100,000 bonds sold at face value
into 2,000 shares of $10 par value common stock. Both
the bonds and the common stock have a market value of
$130,000. Saunders makes the following entry to
record the conversion:
Bonds payable
Chapter
15-30
100,000
Common stock (2,000 x $10)
20,000
Paid-in capital in excess of par
80,000
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Bond Retirements
Question
When bonds are converted into common stock:
a. a gain or loss is recognized.
b. the carrying value of the bonds is transferred
to paid-in capital accounts.
c. the market price of the stock is considered in
the entry.
d. the market price of the bonds is transferred to
paid-in capital.
Chapter
15-31
SO 3 Describe the entries when bonds are redeemed or converted.
Accounting for Other Long-Term Liabilities
Long-Term Notes Payable
May be secured by a mortgage that pledges title to
specific assets as security for a loan
Typically, the terms require the borrower to make
installment payments over the term of the loan. Each
payment consists of
1. interest on the unpaid balance of the loan and
2. a reduction of loan principal.
Companies initially record mortgage notes payable at
face value.
Chapter
15-32
SO 4 Describe the accounting for long-term notes payable.
Accounting for Other Long-Term Liabilities
Illustration: Porter Technology Inc. issues a $500,000,
12%, 20-year mortgage note on December 31, 2010. The
terms provide for semiannual installment payments of
$33,231 (not including real estate taxes and insurance). The
installment payment schedule for the first two years is as
follows.
Illustration 15-12
Chapter
15-33
SO 4 Describe the accounting for long-term notes payable.
Accounting for Other Long-Term Liabilities
Illustration: Porter Technology Inc. issues a $500,000,
12%, 20-year mortgage note on December 31, 2010. The
terms provide for semiannual installment payments of
$33,231 (not including real estate taxes and insurance). The
installment payment schedule for the first two years is as
follows.
Dec. 31
Jun. 30
Chapter
15-34
Cash
Mortgage notes payable
Interest expense
Mortgage notes payable
Cash
500,000
500,000
30,000
3,231
33,231
SO 4 Describe the accounting for long-term notes payable.
Accounting for Other Long-Term Liabilities
Question
Each payment on a mortgage note payable consists
of:
a. interest on the original balance of the loan.
b. reduction of loan principal only.
c. interest on the original balance of the loan and
reduction of loan principal.
d. interest on the unpaid balance of the loan and
reduction of loan principal.
Chapter
15-35
SO 4 Describe the accounting for long-term notes payable.
Chapter
15-36
Accounting for Other Long-Term Liabilities
Lease Liabilities
A lease is a contractual arrangement between a lessor
(owner of the property) and a lessee (renter of the
property).
Illustration 15-13
Chapter
15-37
SO 5 Contrast the accounting for operating and capital leases.
Accounting for Other Long-Term Liabilities
The issue of how to report leases is the case of substance versus
form. Although technically legal title may not pass, the benefits
from the use of the property do.
Operating Lease
Journal Entry:
Rent expense
Cash
xxx
xxx
Capital Lease
Journal Entry:
Leased equipment
Lease liability
xxx
xxx
A lease that transfers substantially all of the benefits and risks of
property ownership should be capitalized (only noncancellable leases
may be capitalized).
Statement of Financial Accounting Standard No. 13,
“Accounting for Leases,” 1976
Chapter
15-38
SO 5 Contrast the accounting for operating and capital leases.
Accounting for Other Long-Term Liabilities
To capitalize a lease, one or more of four criteria
must be met:
1.
Transfers ownership to the lessee.
2. Contains a bargain purchase option.
3. Lease term is equal to or greater than 75 percent of
the estimated economic life of the leased property.
4. The present value of the minimum lease payments
(excluding executory costs) equals or exceeds 90
percent of the fair value of the leased property.
Chapter
15-39
SO 5 Contrast the accounting for operating and capital leases.
Accounting for Other Long-Term Liabilities
Exercise: Gonzalez Company decides to lease new
equipment. The lease period is four years; the economic life
of the leased equipment is estimated to be five years. The
present value of the lease payments is $190,000, which
is equal to the fair market value of the equipment. There is
no transfer of ownership during the lease term, nor is there
any bargain purchase option.
Instructions:
(a) What type of lease is this? Explain.
(b) Prepare the journal entry to record the lease.
Chapter
15-40
SO 5 Contrast the accounting for operating and capital leases.
Accounting for Other Long-Term Liabilities
Exercise: (a) What type of lease is this? Explain.
Capitalization Criteria:
Capital Lease?
1. Transfer of ownership
NO
NO
2. Bargain purchase option
3. Lease term => 75% of
economic life of leased
property
4. Present value of minimum
lease payments => 90% of
FMV of property
Chapter
15-41
Lease term
Economic life
YES
4 yrs.
5 yrs.
80%
YES - PV and FMV
are the same.
SO 5 Contrast the accounting for operating and capital leases.
Accounting for Other Long-Term Liabilities
Exercise: (b) Prepare the journal entry to record the
lease.
Leased asset - equipment
Lease liability
190,000
190,000
The portion of the lease liability expected to be paid in the
next year is a current liability. The remainder is classified
as a long-term liability.
Chapter
15-42
SO 5 Contrast the accounting for operating and capital leases.
Accounting for Other Long-Term Liabilities
Question
The lessee must record a lease as an asset if the
lease:
a. transfers ownership of the property to the
lessor.
b. contains any purchase option.
c. term is 75% or more of the useful life of the
leased property.
d. payments equal or exceed 90% of the fair
market value of the leased property.
Chapter
15-43
SO 5 Contrast the accounting for operating and capital leases.
Statement Analysis and Presentation
Presentation
Chapter
15-44
Illustration 15-14
SO 6 Identify the methods for the presentation
and analysis of long-term liabilities.
Statement Analysis and Presentation
Analysis of Long-Term Debt
Two ratios that provide information about debtpaying ability and long-run solvency are:
1.
Debt to
total assets
=
Total debt
Total assets
The higher the percentage of debt to total assets,
the greater the risk that the company may be
unable to meet its maturing obligations.
Chapter
15-45
SO 6 Identify the methods for the presentation
and analysis of long-term liabilities.
Statement Analysis and Presentation
Analysis of Long-Term Debt
Two ratios that provide information about debtpaying ability and long-run solvency are:
2.
Times
interest
earned
=
Income before income taxes
and interest expense
Interest expense
Indicates the company’s ability to meet interest
payments as they come due.
Chapter
15-46
SO 6 Identify the methods for the presentation
and analysis of long-term liabilities.
Chapter
15-47
Present Value Concepts Related to Bond Pricing
Present Value of Face Value
Appendix 15A
To illustrate present value concepts, assume that you are
willing to invest a sum of money that will yield $1,000 at
the end of one year, and you can earn 10% on your money.
What is the $1,000 worth today?
To compute the answer,
Chapter
15-48

divide the future amount by 1 plus the interest rate
($1,000/1.10 = $909.09 OR

use a Present Value of 1 table. ($1,000 X .90909) =
$909.09 (10% per period, one period from now).
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Face Value
To compute the answer,

divide the future amount by 1 plus the interest rate
($1,000/1.10 = $909.09.
Illustration 15A-1
Chapter
15-49
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Face Value
To compute the answer,

Chapter
15-50
use a Present Value of 1 table. ($1,000 X .90909) =
$909.09 (10% per period, one period from now).
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Face Value
The future amount ($1,000), the interest rate (10%), and
the number of periods (1) are known
Illustration 15A-2
Chapter
15-51
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Face Value
If you are to receive the single future amount of $1,000
in two years, discounted at 10%, its present value is
$826.45 [($1,000 1.10) 1.10].
Illustration 15A-3
Chapter
15-52
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Face Value
To compute the answer using a Present Value of 1 table.
($1,000 X .82645) = $826.45 (10% per period, two
periods from now).
Chapter
15-53
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Interest Payments (Annuities)
In addition to receiving the face value of a bond at
maturity, an investor also receives periodic interest
payments (annuities) over the life of the bonds.
To compute the present value of an annuity, we need to
know:
1)
interest rate,
2) number of interest periods, and
3) amount of the periodic receipts or payments.
Chapter
15-54
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Interest Payments (Annuities)
Assume that you will receive $1,000 cash annually for
three years and the interest rate is 10%.
Illustration 15A-5
Chapter
15-55
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Interest Payments (Annuities)
Assume that you will receive $1,000 cash annually for
three years and the interest rate is 10%.
Illustration 15A-6
Chapter
15-56
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Present Value of Interest Payments (Annuities)
Assume that you will receive $1,000 cash annually for
three years and the interest rate is 10%.
$1,000 annual payment x 2.48685 = $2,486.85
Chapter
15-57
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Computing the Present Value of a Bond
The selling price of a bond is equal to the sum of:
1) The present value of the face value of the bond
discounted at the investor’s required rate of return
PLUS
2) The present value of the periodic interest payments
discounted at the investor’s required rate of return
Chapter
15-58
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Assume a bond issue of 10%, five-year bonds with a face
value of $100,000 with interest payable semiannually on
January 1 and July 1.
Illustration 15A-8
Chapter
15-59
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Assume a bond issue of 10%, five-year bonds with a face
value of $100,000 with interest payable semiannually on
January 1 and July 1.
Illustration 15A-9
Contractual Rate = Discount Rate
Chapter
15-60
Issued at Face Value
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Assume a bond issue of 10%, five-year bonds with a face
value of $100,000 with interest payable semiannually on
January 1 and July 1.
Illustration 15A-10
Contractual Rate < Discount Rate
Chapter
15-61
Issued at a Discount
SO 7 Compute the market price of a bond.
Present Value Concepts Related to Bond Pricing
Assume a bond issue of 10%, five-year bonds with a face
value of $100,000 with interest payable semiannually on
January 1 and July 1.
Illustration 15A-11
Contractual Rate > Discount Rate
Chapter
15-62
Issued at a Premium
SO 7 Compute the market price of a bond.
Effective-Interest Method of Bond Amortization
Appendix 15B
Under the effective-interest method, the amortization
of bond discount or bond premium results in period
interest expense equal to a constant percentage of the
carrying value of the bonds.
Required steps:
1. Compute the bond interest expense.
2. Compute the bond interest paid or accrued.
3. Compute the amortization amount.
Chapter
15-63
SO 8 Apply the effective-interest method of amortizing
bond discount and bond premium.
Effective-Interest Method of Bond Amortization
Amortizing Bond Discount
Assume Candlestick, Inc. issues $100,000 of 10%, five-year
bonds on January 1, 2010, for $92,639, with interest
payable each July 1 and January 1. This results in a discount
of $7,361.
Illustration 15B-2
Chapter
15-64
SO 8 Apply the effective-interest method of amortizing
bond discount and bond premium.
Effective-Interest Method of Bond Amortization
Amortizing Bond Discount
Assume Candlestick, Inc. issues $100,000 of 10%, five-year
bonds on January 1, 2010, for $92,639, with interest
payable each July 1 and January 1. This results in a discount
of $7,361.
Journal entry on July 1, 2010, to record the interest
payment and amortization of discount is as follows:
July 1
Interest Expense
Cash
5,000
Discount on Bonds Payable
Chapter
15-65
5,558
558
SO 8 Apply the effective-interest method of amortizing
bond discount and bond premium.
Effective-Interest Method of Bond Amortization
Amortizing Bond Premium
Assume Candlestick, Inc. issues $100,000 of 10%, five-year
bonds on January 1, 2010, for $108,111, with interest
payable each July 1 and January 1. This results in a premium
of $8,111.
Illustration 15B-4
Chapter
15-66
SO 8 Apply the effective-interest method of amortizing
bond discount and bond premium.
Effective-Interest Method of Bond Amortization
Amortizing Bond Premium
Assume Candlestick, Inc. issues $100,000 of 10%, five-year
bonds on January 1, 2010, for $108,111, with interest
payable each July 1 and January 1. This results in a premium
of $8,111.
Journal entry on July 1, 2010, to record the interest
payment and amortization of premium is as follows:
July 1
Interest Expense
Premium on Bonds Payable
Cash
Chapter
15-67
4,324
676
5,000
SO 8 Apply the effective-interest method of amortizing
bond discount and bond premium.
Straight-Line Amortization
Amortizing Bond Discount
Appendix 15C
Candlestick, Inc., sold $100,000, five-year, 10% bonds on
January 1, 2010, for $92,639 (discount of $7,361). Interest
is payable on July 1 and January 1. The bond discount
amortization for each interest period is $736 ($7,361/10).
Illustration 15C-2
Chapter
15-68
SO 9 Apply the straight-line method of amortizing
bond discount and bond premium.
Straight-Line Amortization
Amortizing Bond Discount
Candlestick, Inc., sold $100,000, five-year, 10% bonds on
January 1, 2010, for $92,639 (discount of $7,361). Interest
is payable on July 1 and January 1. The bond discount
amortization for each interest period is $736 ($7,361/10).
Journal entry on July 1, 2010, to record the interest
payment and amortization of discount is as follows:
July 1
Interest Expense
Discount on Bonds Payable
Cash
Chapter
15-69
5,736
736
5,000
SO 9 Apply the straight-line method of amortizing
bond discount and bond premium.
Copyright
“Copyright © 2009 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act without
the express written permission of the copyright owner is
unlawful. Request for further information should be addressed
to the Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up copies for his/her own use only
and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the
use of these programs or from the use of the information
contained herein.”
Chapter
15-70