CHAPTER 14
LONG-TERM LIABILITIES
SECTION 1: Bonds Payable
For January 27: Read pages 711-725. Answer questions 1-25.
For January 29: Answer questions 26-51.
For February 3: Read pages 725-736. Answer questions 52-67.
1. What is the definition of long-term debt? Give several examples.
2. Give some examples of items included in a bond indenture or note agreement.
3. When/why do companies choose bonds over notes to raise large sums of capital?
4. What is the most common denomination for bonds ($100, $1,000 or $10,000)?
5. How often do most bonds pay interest?
6. Review the terms in the blue boxes on pages 713-714. Be sure you understand
these.
7. What does the quality ratings given by Moody’s or Standard and Poor’s tell about
a company’s bonds? Does an AAA (Aaa) rating mean that the bonds are a good
investment? Why or why not?
8. If two companies issue identical bonds and Company A receives an AAA rating
from S&P while Company B receives a BBB rating, which bond will sell for a
higher price?
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BOND
Ameen Company, for value received, hereby promises to pay to the bearer on the thirtyfirst day of December 31, 2005, the sum of ONE THOUSAND DOLLARS ($1,000),
and to pay interest on such principal sum from the date issued at the rate of FIVE AND
85/100 PERCENT (5.85%) per year, payable June 30, 2003, and semi-annually
thereafter on the thirty-first day of December and the thirtieth day of June in each year
until maturity of the bond.
9. What is the $1,000 called?
10. What is the 5.85% called?
11. What is the term of the bond?
EXAMPLE 1
12. If the Ameen Company wants to borrow $4,000,000, how many bonds will be
issued?
13. What amounts must the Ameen Company pay to the purchasers of the bonds?
Give dates and total amounts.
14. How did the Ameen Company choose the 5.85% rate? See footnote 3 on pg 715.
15. Assume that the Ameen Company sold (issued) the bonds on December 31, 2002,
at 100 (face value, par). How much cash did Ameen Co. receive?
16. What does this suggest about the market rate of interest on December 31, 2002,
for companies similar to Ameen Co.?
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17. Prepare the journal entry to record the issuance of the bonds.
18. Prepare the journal entry to record the first interest payment on June 30, 2003.
19. For this example only, assume the company uses October 31 as its fiscal year-end.
Prepare the adjusting entry related to the bond interest on October 31, 2003.
20. Prepare the entry to record the second interest payment on December 31, 2003.
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EXAMPLE 2
Assume that Ameen Company was not able to sell the bonds on December 31, 2002, and
the bonds were not issued until February 28, 2003. The bonds were issued at 100 plus
accrued interest.
21. Why must investors pay accrued interest on the bonds?
22. How much cash did Ameen Co. receive for the bonds, excluding the accrued
interest?
23. How much cash did Ameen Co. receive for the accrued interest?
24. Prepare the journal entry for the issuance of the bonds on February 28, 2003.
25. Record the first interest payment on June 30, 2003.
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EXAMPLE 3
Assume that before the bonds are issued on December 31, the market rate of interest
for these bonds increases to 6%. This could be due to changes in the economy
(interest rates in general are rising); changes in the industry (outlook is not as good as
before); or changes in the Ameen Co. (losing market share, involved in litigation,
etc.).
26. Can Ameen Co. still sell these 5.85% bonds? If so, how?
27. The bonds will sell for $3,983,731. Prove this by calculating the present value of
the interest payments and the present value of the maturity value.
28. What is the total amount of interest to be paid by Ameen Co.? (Hint: Calculate
the total payments to be made to the bondholders and subtract the amount
received from the bondholders.)
29. Record the issuance of the bonds on December 31, 2002.
30. How would these bonds appear on a balance sheet prepared on December 31,
2002?
31. What kind of account is DISCOUNT ON BONDS PAYABLE? What does the
amount in this account represent?
32. When do we recognize this discount as interest expense?
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33. One method for amortizing the bond discount is the straight-line method. This
method is only acceptable if the results are not materially different from the
required method (effective interest method). Under the SL method, the amount of
discount amortization each period is calculated as:
Discount amortized = total discount / # of interest periods
Interest expense = cash paid + discount amortized
34. Record the first interest payment and discount amortization on June 30, 2003.
Round to the nearest dollar.
35. Record the adjusting entry related to the bonds on December 31, 2003.
36. GAAP requires companies to use the effective interest method to amortize bond
discounts. The effective interest method calculates interest expense using the
effective interest rate (market rate), in this case, 6%. This rate is applied to the
carrying value (book value) of the bonds (face value – unamortized discount).
Calculate the interest expense and discount to be amortized on June 30, 2003.
INTEREST
EXPENSE
= CARRYING
VALUE
*
EFFECTIVE
RATE
*
TIME
DISCOUNT AMORTIZED = INTEREST EXPENSE - CASH PAID
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37. Record the first interest payment and discount amortization on June 30, 2003,
using the effective interest method and the amounts computed in #36.
38. Calculate the interest expense and discount to be amortized for the second 6months.
CARRYING VALUE = FACE VALUE – UNAMORTIZED DISCOUNT
(or NEW CARRYING VALUE = PREVIOUS CARRYING VALUE +
DISCOUNT AMORTIZED)
INTEREST
EXPENSE
= CARRYING
VALUE
*
EFFECTIVE
RATE
*
TIME
DISCOUNT AMORTIZED = INTEREST EXPENSE - CASH PAID
39. Use the above calculations to prepare the adjusting entry on December 31, 2003.
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40. It is useful to prepare a schedule of discount amortization when the bonds are
issued. This makes recording the journal entries much easier. Prepare a schedule
of bond discount amortization using the effective interest method for the Ameen
Co. bonds.
AMEEN COMPANY
SCHEDULE OF DISCOUNT AMORTIZATION
EFFECTIVE INTEREST METHOD – SEMIANNUAL INTEREST
3-YEAR, 5.85% BONDS SOLD TO YIELD 6%
Date
Cash Paid
Interest Expense
Discount
Amortized
Carrying
Value
Dec 31, 2002
June 30, 2003
Dec 31, 2003
June 30, 2004
Dec 31, 2004
June 30, 2005
Dec 31, 2005
EXAMPLE 4
Assume instead that the Ameen Co. bonds were sold on December 31, 2002, when
the market rate of interest for similar bonds was 5%.
41. The bonds sold for $4,093,651. Prove this by calculating the present value of the
interest payments and the present value of the maturity value.
42. The bonds sold at a premium. What happens to this premium? Does the Ameen
Co. get to keep this money?
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43. Calculate the total amount of interest expense over the life of the bonds.
44. Record the issuance of the bonds on December 31, 2002.
45. How is the Premium on Bonds Payable account classified?
46. Prepare a schedule of premium amortization for the bonds.
AMEEN COMPANY
SCHEDULE OF PREMIUM AMORTIZATION
EFFECTIVE INTEREST METHOD – SEMIANNUAL INTEREST
3-YEAR, 5.85% BONDS SOLD TO YIELD 5%
Date
Cash Paid
Interest Expense
Premium
Amortized
Carrying
Value
Dec 31, 2002
June 30, 2003
Dec 31, 2003
June 30, 2004
Dec 31, 2004
June 30, 2005
Dec 31, 2005
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47. Record the first interest payment on June 30, 2003, using the effective interest
method.
EXAMPLE 5
When bonds are issued, the corporation incurs costs for engraving and printing the
certificates, legal and accounting fees, commissions, promotion fees, etc. These are
called bond issue costs and must be recorded and amortized over the life of the bonds.
The bond issue costs account is considered a deferred charge (asset) and is typically
shown under the other assets category on the balance sheet.
48. Assume that Ameen Co. issues the bonds at 99.6 on December 31, 2002. Bond
issue costs were $24,000. Record the issuance.
49. The Ameen Co. uses the straight-line method of amortizing bond issue costs (as
do most other companies). The results are not materially different from the
effective interest method. Record the amortization of the bond issue costs on
December 31, 2003. Ameen Co. prepares this entry only once per year.
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EXAMPLE 6
50. Record the retirement of the Ameen Co. bonds on December 31, 2005, the
maturity date.
51. Assume instead that the bonds were retired (extinguished) before maturity. The
bonds were purchased in the open market at 101. The bonds were carried on the
books as follows on the date of retirement:
Bonds Payable
$4,000,000
Premium on Bonds Payable
32, 780
Bond Issue Costs
10,000
a. Calculate the cash paid for the bonds.
b. Calculate the net carrying value of the bonds including bond issue costs.
c. Calculate the gain or loss on extinguishments (cash paid – net carrying value).
d. Record the retirement of the bonds.
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NOTE: The gain or loss on extinguishment of debt is no longer classified as an
extraordinary item.
CHAPTER 14: SECTION 2
SECTION 2: LONG-TERM NOTES PAYABLE
EXAMPLE 1: Notes issued at face value
On December 31, 2001, the Wilkins Company borrowed $50,000 cash by signing a
$50,000, 12%, 3-year note at First National Bank. Interest is to be paid annually on
December 31 and the principal is to be paid at maturity. The effective rate of the note is
12%.
52. Record the issuance of the note on December 31, 2001:
53. Record the first interest payment on December 31, 2002:
EXAMPLE 2: Zero-interest-bearing note
On January 1, 2002, the Catrett Company signed a 5-year, $200,000 note payable and
received cash of $124,184. The note has no stated interest rate.
54. Record the issuance of the note:
55. Determine the effective interest rate of the note:
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56. Record the adjusting entry related to interest on the note on December 31, 2002, using
the effective interest rate method.
57. Record the adjusting entry related to interest on the note on December 31, 2003,
using the effective interest method.
EXAMPLE 3: Notes issued with stated rate not equal to effective rate:
On December 31, 2001 the Akin Company issued a $60,000, 5-year note bearing interest
at 8% (interest is to be paid annually on December 31) to Dyer Company for cash. The
market rate of interest on similar notes is 12%.
58. Compute the cash proceeds received by Akin. (Hint: treat this like a bond)
59. Record the issuance of the note:
60. Record the interest payment on December 31, 2002 using the effective interest
method.
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EXAMPLE 4: Notes issued for Property, Goods or Services when
1. there is no stated interest rate (i.e., non-interest-bearing note)
2. the stated rate is unreasonable (i.e., 2% stated rate when 8% is reasonable)
3. the stated face amount of the debt instrument is materially different from the cash
sales price of the item or the current market value of the debt.
In the above situations, we must impute an effective interest rate by using as the present
value of the note one of the following:
1. the current cash sales price of the item
2. the current market value of the note
When neither of these is known, we must determine the effective interest rate by looking
at the credit rating of the issuer. (i.e., What rate of interest would they be expected to
pay?)
EXAMPLE 4-a:
The Mercer Company issued a $146,933, 5-year, non-interest-bearing note in exchange
for a machine with a cash price of $100,000.
61. Determine the implied interest rate for the note.
62. Record the purchase of the machine.
EXAMPLE 4-b:
The Conley Company purchased a used machine (with no established second-hand
market) from Reed Company. Conley Company signed a $100,000, 2-year note with no
stated interest rate. Neither the value of the machine nor the note is determinable.
Conley’s incremental borrowing rate is 12% while Reed’s incremental borrowing rate is
10%.
63. Compute the purchase price of the machine (i.e., the present value of the note).
64. Record the purchase of the machine.
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SECTION 3:
REPORTING AND ANALYSIS OF LONG-TERM DEBT
65. What are three ways in which companies may keep debt off the balance sheet?
66. Why do companies attempt to keep debt off the balance sheet?
67. What ratios are used to analyze long-term debt? Give the formulas.
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