CHAPTER 15 … Long-Term Liabilities
Chapter Outline
Bonds payable: An introduction
A.
Bonds payable are groups of notes issued to many lenders (bondholders).
1.
2.
B.
C.
Purchasers receive a bond certificate bearing the name of the issuer that includes
the following information:
a.
The principal—the amount the company has borrowed. The principal,
also referred to as the maturity value, or par value, is usually stated in
multiples of $1,000.
b.
The maturity date—the date on which the principal amount must be
repaid to the bondholder.
c.
The stated interest rate and the interest dates (generally semi-annually).
Exhibit 15-1 is an example of a bond certificate.
Types of bonds include:
1.
Term bonds—mature on a specific date.
2.
Serial bonds—mature in installments.
3.
Secured, or mortgage, bonds—give the bondholder the right to take specific
assets (called collateral) if the company defaults (fails to pay interest or
principal).
4.
Unsecured, or debenture, bonds—are backed only by the good faith of the
borrower.
A bond is issued at a premium when issued at a price above its maturity value. A bond
is issued at a discount when issued at a price below its maturity value.
15-1
D.
E.
1.
As a bond approaches the maturity date, the price of a bond moves toward its
maturity value.
2.
The market value is equal to the maturity value (par value) on the maturity date.
3.
Refer to Exhibit 15-2 to see how bond information is quoted in the Wall Street
Journal.
The purchase price of a bond, the amount an investor is willing to pay for it, is affected
by the time value of money—the fact that money earns income over time.
1.
The amount a person would pay at the present time to receive a greater amount at
a future date is the present value. (Refer to the Appendix for a detailed
discussion.)
2.
The present value is always less than the future value.
Two interest rates work to set the market price of a bond—the stated interest rate and
the market interest rate. The market price is the maximum amount that an investor will
pay for a bond.
1.
The stated interest rate (or contract rate) determines the cash interest paid. The
stated rate is set by the bond stated and does not change during the life of the
bonds.
2.
The market interest rate (or effective rate) is the rate investors demand for
loaning their money and may vary from day to day. (Exhibit 15-3 summarizes
how these two interest rates interact to determine bond prices.)
a.
If investors demand a higher rate than the stated rate, the bonds will sell at
a discount.
b.
If investors demand a lower rate than the stated rate, the bonds will sell at
a premium.
15-2
Objective 1: Account for bonds payable
A.
Journal entries for bonds issued at maturity (par) value on an interest date follow:
1.
On the date of issuance:
Cash
XX
Bonds Payable
XX
2.
3.
B.
On the interest payment date:
Interest Expense
XX
Cash
XX
On the maturity date:
Bonds Payable
Cash
XX
XX
Bonds are issued at a discount because the market interest rate is greater than the stated
interest rate. The account, Discount on Bonds Payable, a contra account, records the
difference between the issue price and the maturity value. This account balance must be
amortized (reduced) over the life of the bonds.
1.
The entry to record the issuance of bonds at a discount is:
Cash
XX
Discount on Bonds Payable XX
Bonds Payable
XX
2.
The bonds are reported as a long-term liability as follows:
Bonds Payable (par value)
Less: Discount on Bonds Payable
$XX
XX
$XX
Objective 2: Measure interest expense by the straight line amortization method
A.
An entry is recorded on each semiannual interest payment date to record the
interest payment and the amortization of the discount. The discount is accounted
for as interest expense.
1.
Cash interest paid + Discount amortization = Interest expense
15-3
2.
Under straight-line amortization, the amount that is amortized is divided
equally over each semiannual interest period and is recorded as follows:
Interest Expense
XX
Cash
XX
Discount on Bonds Payable XX
B.
3.
Amortization of the discount reduces the balance of Discount on Bonds Payable,
thus increasing the carrying amount of the bonds.
4.
On the maturity date, the Discount on Bonds Payable will be completely
amortized (have a zero balance), and the carrying amount will be equal to the
maturity value.
Bonds are issued at a premium when the market interest rate is less than the stated
interest rate. The account, Premium on Bonds Payable is added to Bonds Payable to
show the carrying amount of the bonds. This account must also be amortized over the
life of the bonds.
1.
Issuance of bonds at a premium is rare, because companies don’t like to pay a
higher rate than the market rate. The entry to record the issuance of bonds at a
premium is:
Cash
XX
Bonds Payable
XX
Premium on Bonds Payable XX
2.
The following entry is recorded on each semiannual interest payment date to
record the interest payment and the amortization of the premium. The premium
is like a savings of interest and thus reduces interest expense.
a.
Cash interest paid – Premium amortization = Interest expense
b.
The entry to record the interest payment and amortization of the premium
is:
Interest Expense
XX
Premium on Bonds Payable XX
Cash
15-4
XX
C.
Bonds payable are reported on the balance sheet at maturity value plus any bond
premium or minus bond discount. Over the life of the bonds, the balance of any
premium/discount will be reduced to zero.
Bonds Payable (par value)
Plus: Premium on Bonds Payable (unamortized portion)
D.
$XX
XX
$XX
Decision Guidelines help provide answers to important questions about bonds.
Objective 3: Account for retirement and conversion of bonds payable
A.
If the year-end is not an interest-payment date, an entry is required to accrue interest and
to amortize a portion of the premium or discount based on the number of months
since the last interest date. This entry results in both the correct amount of interest
expense and the correct carrying amount.
1.
The year-end accrual is:
Bonds issued at a discount
Interest Expense
XX
Interest Payable
XX
Discount on Bonds Payable
XX
Bonds issued at a premium
Interest Expense
XX
Premium on Bonds Payable
XX
Interest Payable
XX
2.
The next semiannual interest payment is recorded as follows:
Bonds issued at a discount
Bonds issued at a premium
Interest Expense
XX
Interest Expense
XX
Interest Payable
XX
Interest Payable
XX
Cash
XX
Premium on Bonds Payable
XX
Discount on Bonds Payable
XX
Cash
XX
B.
Bonds issued between interest dates are sold at their market value plus accrued
interest, that is, the interest since the last semiannual interest date.
1.
The entry to record the issuance is:
15-5
Cash
XX
Bonds Payable
Interest Payable
2.
D.
XX
On the next interest date, the issuer will pay six months’ interest; however, the
interest expense recorded is for the amount of time the bonds have been
outstanding.
Interest Payable
Interest Expense
Cash
C.
XX
XX
XX
XX
Normally, companies wait until maturity to pay off bonds payable. If a company wants
to retire the bonds early, two options exist.
1.
If the bonds are callable, the issuer may call the bonds, that is, retire the bonds at
some specified price (usually above par).
2.
Alternatively, the company may purchase the bonds at the current market
price. In either case, the journal entry is the same.
Follow these steps when retiring bonds before maturity:
1.
Record partial-period amortization of discount or premium.
2.
Write off the portion of Discount or Premium that relates to the portion of bonds
being retired.
3.
Compute the gain or loss on retirement.
Loss on retirement of bonds issued at a discount Gain on retirement of bonds issued at a
premium
Bonds Payable
XX
Bonds Payable
XX
Discount on Bonds Payable
XX
Loss on Retirement of Bonds
XX
Cash
XX
Premium on Bonds Payable
XX
Gain on Retirement of Bonds
XX
Cash
XX
E.
Convertible bonds payable allow the bondholder the option to exchange the bonds for
common stock.
15-6
1.
Bondholders may convert if the market price of the common stock gets high
enough.
2.
The carrying amount of the bonds becomes the amount of the new stockholders'
equity.
3.
The journal entry removes bonds payable and the related unamortized premium or
discount from the accounts and increases common stock and paid-in capital in
excess of par; no gain or loss is recorded.
Conversion of bonds issued at a discount
Conversion of bonds issued at a premium
Bonds Payable
XX
Bonds Payable
XX
Discount on Bonds Payable
XX
Premium on Bonds Payable
XX
Common Stock
XX
Common Stock
XX
Paid-in Capital in Excess of Par XX
Paid-in Capital in Excess of Par XX
F.
Serial bonds are payable in installments. The portion of the bonds payable within one
year—the current portion of long-term debt—is reported as a current liability; the
remainder is considered long-term.
Objective 4 is missing from the original file – nothing to check
Objective 5: Show the advantages and disadvantages of borrowing
A.
The advantage of issuing bonds payable is that it is a cheaper source of money.
Borrowing can help increase a company’s earnings per share of common stock.
Exhibit 15- 4.)
(See
B.
The advantage of issuing common stock is that it is less risky than borrowing money.
C.
Decision Guidelines review important concepts about bonds payable.
15-7
Appendix to Chapter 15
A.
The term time value of money refers to the fact that money earns interest over time.
Interest is the cost of using money. The process of computing a future value is called
accumulating because the future value is more than the present value.
B.
The present value (PV) is the amount that would have to be invested now to accumulate
to some specified future amount. The process of computing present value is called
discounting.
1.
2.
Present value depends on three factors:
a.
The amount of the payment (receipt).
b.
The length of time between investment and future receipt (payment).
c.
The interest rate.
Present value can be calculated by using a formula that is the reciprocal of the
future value formula:
Future value
= Present
(1 + Interest rate)
Value
3.
The present value of a single sum can also be computed using the Present Value
of $1 table (Exhibit 15A- 1). Find the factor in the table that corresponds with the
number of interest periods and the interest rate. Multiply that factor by the future
value.
4.
The present value of an annuity is determined by using the factors in the Present
Value of an Annuity table (Exhibit 15-A 2). To compute the present value of an
annuity, find the factor in the table that corresponds with the number of periods
and the interest rate. Multiply that factor by the amount of the periodic payment
(receipt).
5.
The present value techniques can be applied to determining the market price of a
bond. The market price of a bond is determined by making two computations:
a.
First compute the PV of the principal. Multiply the principle by the
appropriate factor in Present Value of $1 table.
15-8
C.
D.
b.
Then compute the PV of the interest payments. Multiply one interest
payment amount by the appropriate factor in the Present Value of an
Annuity table.
c.
Add the amounts from a. and b. to determine the market price of the
bonds.
The effective-interest method of amortization is another method of amortizing
premium or discount and is considered preferable to the straight-line method.
1.
Under the straight-line method, the interest expense is the same dollar amount
each period. Under the effective-interest method, the interest expense is a
constant percentage of the bonds’ carrying amount.
2.
GAAP requires that interest expense be measured using the effective-interest
method unless the difference between the effective-interest method and the
straight-line method is immaterial.
3.
The total amount of premium or discount amortized is the same under the two
methods; the total expense is the same.
When using the effective-interest method, an amortization table is helpful. The table
has the following headings as shown in Exhibit 15-A3 (discount) and Exhibit 15-A4
(premium):
1.
Semiannual Interest Period
2.
Column A: Interest Payment—stated rate (semiannual) x maturity value
3.
Column B: Interest Expense—market rate (semiannual) x carrying amount
4.
Column C: Discount / Premium Amortization—difference between columns A
and B
5.
Column D: Discount or Premium Balance—previous balance – column C
6.
Column E: Bond Carrying Amount:
a.
b.
For bonds issued at a discount—maturity value – column D
For bonds issued at a premium— maturity value + column D
15-9
E.
The accounts debited and credited are the same under the effective-interest method and
the straight-line method. Only the amounts are different. These entries are summarized
below with a column reference from the amortization table.
Bonds issued at a discount
Bonds issued at a premium
At issuance
Cash (E)
XX
Cash (E)
XX
Discount on Bonds Payable (D)
XX
Bonds Payable
XX
Bonds Payable
XX
Premium on Bonds Payable (D)
XX
To pay interest
Interest Expense (B)
XX
Interest Expense (B)
XX
Discount on Bonds Payable (C) XX
Premium on Bonds Payable (C)
XX
Cash (A)
XX
Cash (A)
XX
To accrue interest
Interest Expense (B)
XX
Interest Expense (B)
XX
Interest Payable (A)
XX
Premium on Bonds Payable (C)
XX
Discount on Bonds Payable (C)
XX
Interest Payable (A)
XX
To pay interest following accrual
Interest Expense (B)
XX
Interest Expense (B)
XX
Interest Payable (A)
XX
Premium on Bonds Payable (C)
XX
Discount on Bonds Payable (C)
XX
Interest Payable (A)
XX
Cash (A)
XX
Cash (A)
XX
Note: the amounts from the table must be adjusted for partial periods when interest is accrued
and in the following entry when the payment is made.
F.
When bonds are issued at a discount, the carrying amount increases each period until
maturity.(Exhibit 15-A3).
G.
When bonds are issued at a premium, the carrying amount increases each period until
maturity. (Exhibit 15-A4).
15-10