BUS210
Accounting for Financing
Decisions:
Long-Term Liabilities
Liabilities
• Current or Short-term Liabilities
• Long-term Debt (borrowed funds)
• Lease Liabilities
• Deferred Taxes
• Contingencies and Commitments
Accounting for liabilities is a subject that can be very
technical. There is a tendency for some institutions
to create exotic instruments for marketing of funds in
recent years. Despite this, there are some basic
principles that govern the accounting for liabilities….
Basis for Valuing Liabilities
• Because money has time value, the amount of money
needed today to pay a future debt is less than the future
obligation.
• Historically, the best basis for valuing a liability was its
economic present value (the present value of the future
cash flows, i.e., the amount of money that would have to
be set aside today to accumulate to the future cash flows
required to pay the interest and the principal of the debt).
• Most current liabilities are reported on the BS at their face
(or nominal value)—the amount that will be paid.
• Most Long-term liabilities are reported on the BS at their
present value (the time-discounted value of the future cash
flows).
Basic Definitions and Different Contractual Forms
Some contracts, called interest-bearing obligations, require
periodic (annual or semiannual) cash payments (called
interest) that are determined as a percentage of the face,
principal, or maturity value, which must be paid at the end of
the contract period.
Non-interest-bearing obligations, on the other hand, require
no periodic payments, but only a single cash payment at the
end of the contract period.
These contractual forms may contain additional terms that
specify assets pledged as security or collateral in case the
required cash payments are not met (default), as well as
additional provisions (restrictive covenants).
Short-term Liabilities
• Report at Face value: Accounts payable, Accrued
expenses, Unearned revenue, Taxes payable, Warranties
payable
• Non-interest bearing ST Notes Payable generally are
reported at maturity value less any unamortized interest
discount. i.e., BS shows either: Note payable $950 or
Note payable $1,000 less Unamortized discount $50.
• Interest-bearing ST Notes Payable generally are reported
at the maturity (face) value plus any accrued interest.
i.e., Note Payable $1,000 and Interest payable $50 on BS.
• Short-term debt which company has no intentions of
liquidating, but plans to continually refinance, should be
classified as long-term. Also, the current portion (the
amount that will be paid within one year) of any longterm debt should be classified on the BS as a current
liability.
Long-term Debts
• Since interest accounts for the difference between the
amount received and the amount paid back, the interest
rate is the basis for computing interest.
• On all long-term debt contracts there are two interest
rates: The stated rate and the effective rate, they may
not be the same…
• The stated rate is the interest rate on interest-bearing
debt that is used to calculate the amount of cash interest
payments that will be made to the lender.
• The effective rate is the compounded interest rate that
mathematically accounts for the total difference
between the amount borrowed and the amount repaid.
Bond Terminology
 Key Questions:
-Present Value? Issue value or Proceeds
-Future Value? Maturity value or Face value
-n= number of periods?
-r=effective or market interest rate?
-Bond or Note stated rate or face rate?
-Single payment or Ordinary annuity (multiple
payments)?
-Interest bearing or Noninterest bearing? What
is the interest payment? How often?
Draw a Timeline and fill in:
-Issue date
-When pay interest and amortize discount
or premium
-Maturity date
BE11-2 Bond Terms
In October 1997 HP issued zero-coupon bonds with a face
of 1.8 billion, due in 2017, for proceeds of $968 million.
a. What is the life of these bonds?
b. What is the stated rate on these bonds?
c. Estimate the effective interest rate of these
bonds. (hint: $PV/$FV = approximate Table value)
d. How many bonds did HP issue?
e. What entry did HP make when the bonds were
issued?
E11-8 Present Value of a Non-interest-bearing Note
Purchased a building 1.1.2015 in exchange for a 3
year non-interest-bearing note with a face of
$693,000. Building appraisal is $550,125.
a. What amount should this building be
capitalized?
E11-8 Present Value of a Non-interest-bearing Note
Purchased a building 1.1.2015 in exchange for a 3 year non-interestbearing note with a face of $693,000. Building appraisal is $550,125.
b. Compute the present value of the note’s future cash
flows, using the following discount rates:
1. 6 percent
2. 8 percent
3. 10 percent
c. What is the effective rate of this note?
d. Explain how one could more quickly compute the effective interest
rate on the note.
E11-5 Discounted Non-interest-bearing Notes
Purchase equipment with a FMV of $11,348 in exchange for
a 5 year non-interest-bearing note with a face of $20,000.
a. Compute the effective interest rate on the note payable.
b. Prepare entry to record the purchase.
E11-5 Discounted Non-interest-bearing Notes
Purchase equipment with a FMV of $11,348 in exchange for a 5
year non-interest-bearing note with a face of $20,000.
c. How much interest expense should be recognized in the first
year?
d. What is the BS value of the note at the end of the first year?
e. Will the interest expense recognized in the second year be greater,
equal, or less than the interest expense recognized in the first year?
Why?
f. Will the interest expense recognized in the third year be greater,
equal, or less than the interest expense recognized in the second
year? Why?
E11-7 Effective Interest Rate
On 1.1.15 a company borrowed $2,413 from the bank. The
$2,500 note had a maturity date of 12.31.16 and specified an
interest rate of 8 percent. (interest $200)
a. Compute the PV of the note at the following discount rates:
a.
8%
b.
10%
c.
12%
b. What is the effective rate of the note?
c.
Determine the effective rate if originally borrowed $2,500.
E11-9 Effective Interest Rate
What is the effective interest rate on the note payable?
2016
2015
Balance Sheet
Note Payable
Less: Discount on NP
$200,000 $200,000
12,000
14,400
16,400
16,200
Income Statement
Interest Expense
Prepare the journal entry to record 2016 interest expense.
E11-4 Non-interest-bearing Note Payable Proceeds
Compute the proceeds from the following notes
payable. Interest payments are made annually.
PV
Principal
PV Interest
Payments
= Proceeds Stated Rate
Effective
Rate
Face Value
Life
0%
8%
$1,000
4 years
0%
6%
$5,000
6 years
Recap: Non-Interest Bearing Notes and Bonds
>Issue date
>Amortize discount
>Maturity date
Accounting for Non-Interest Bearing Notes Payable Recap
Sample Non-interest bearing Long-term Notes Payable
• Problem 1: On January 2, 2008, Pearson Company purchases a
section of land for its new plant site. Pearson issues a 5 year noninterest bearing note, and promises to pay $50,000 at the end of
the 5 year period. What is the cash equivalent price of the land, if
a 6 percent discount rate is assumed?
PV1 = 50,000 x ( 0.74726) = $37,363
[ i=6%, n=5]
Journal entry Jan. 2, 2008:
Dr. Land
Dr. Discount on N/P
Cr. Notes Payable
37,363
12,637
50,000
Sample Problem 1 Solution, continued
The Effective Interest Method:
Interest Expense =
Carrying value x Effective interest rate x Time period
(CV)
(Per year)
(Portion of year)
Where carrying value = face - discount.
For Example 1, CV= 50,000 - 12,637 = 37,363
Interest expense = 37,363 x 6% per year x 1year
= $2,242
Sample Problem 1 Solution, continued
Journal entry, December 31, 2008:
Interest expense
Discount on N/P
2,242
2,242
Carrying value on B/S at 12/31/2008:
Notes Payable
Discount on N/P
(Discount = $12,637 - 2,242 = $10,395)
$50,000
(10,395)
$39,605
Sample Problem 1 Solution, continued
Interest expense at Dec. 31, 2009:
39,605 x 6% x 1 = $2,376
Journal entry, December 31, 2009:
Interest expense
Discount on N/P
2,376
Carrying value on B/S at 12/31/2009:
Notes Payable
$50,000
Discount on N/P
(8,019)
2,376
$41,981
(Discount = 10,395 - 2,376)
Carrying value on 12/31/2012 (before retirement)?
$50,000
Time Value of Money and Interest bearing LongTerm Liabilities: Notes, Bonds, and Leases
• Long-term liabilities are recorded at the present value of the
future cash flows.
• Two components determine the “time value” of money:
– interest (discount) rate
– number of periods of discounting
• Types of activities that require PV calculations:
– notes payable
– bonds payable and bond investments
– capital leases
Interest bearing: Bond Prices
E 11-3 Bond Terms
The stated and effective interest rates for several
notes and bonds follow:
Is Note or Bond issued a
Par, Premium, or
Discount?
Bond Stated Interest Rate
Effective or Market
Interest Rate
1.
10%
10%
2.
7%
8%
3.
9%
8%
4.
11.5%
9%
E11-4 Interest-bearing and Non-interest-bearing Note Payable Proceeds
Compute the proceeds from the following notes
payable. Interest payments are made annually.
PV
Principal
PV Interest
Payments
= Proceeds Stated Rate
Effective
Rate
Face Value
Life
4%
12%
$8,000
6 years
8%
8%
$3,000
7 years
10%
6%
$10,000
10 years
Bonds Payable Issued at a Discount
• If bonds are issued at a discount, the carrying value
will be below face value at the date of issue.
• The Discount on B/P account has a normal debit
balance and is a contra to B/P (similar to the
Discount on N/P).
• The Discount account is amortized with a credit.
Note that the difference between Cash Paid and
Interest Expense is still the amount of amortization.
• Interest expense for bonds issued at a discount will
be greater than cash paid.
• The amortization table will show the bonds
amortized up to face value.
E11-13 Bonds issued at a Discount
Issued 500 five-year bonds on 7.1.15. Interest payments
are due semiannually at 1.1 and 7.1 at an interest rate of
6%. The effective rate is 8%. The face value of each bond
is $1,000.
a. 7.1.15 entry when bonds are issued?
b. 12.31.15 entry at yearend?
E11-13 Bonds issued at a Discount
Issued 500 five-year bonds on 7.1.15. Interest payments are due
semiannually at 1.1 and 7.1 at an interest rate of 6%. The effective
rate is 8%. The face value of each bond is $1,000.
c. 12.31.15 Balance sheet value?
d. PV of bonds remaining cash flows as of 12.31.15?
Your Turn
E11-14 Bonds issued at a Premium
Issued 100 ten-year bonds on 7.1.15. Interest
payments are due semiannually (1.1 and 7.1) at an
annual rate of 8%. The effective rate is 6%. The face of
each bond is $1,000.
a. 7.1.15 entry to issue bonds?
b. 12.31.15 entry?
E11-14 Bonds issued at a Premium
Issued 100 ten-year bonds on 7.1.15. Interest
payments are due semiannually (1.1 and 7.1) at an
annual rate of 8%. The effective rate is 6%. The face of
each bond is $1,000.
c. 12.31.15 balance sheet value?
d. PV of remaining cash flows as of 12.31.15?
Your Turn
E11-11 Bonds
Interest payments are made semi-annually on these bonds:
Bond
Issuance
Face Value
Stated
Interest Rate
Effective
Interest Rate
Life
A
$110,000
6%
6%
10 years
B
$400,000
8%
6%
10 years
C
$600,000
6%
8%
5 years
a.
Compute the proceeds of each bond.
b.
c.
Will the BS value increase, decrease, or remain constant over life of bond?
Will the interest expense increase, decrease, or remain constant over life of
bond?
E11-11 Bonds
Interest payments are made semi-annually on these bonds:
Bond
Issuance
Face Value
Stated
Interest Rate
Effective
Interest Rate
Life
A
$110,000
6%
6%
10 years
B
$400,000
8%
6%
10 years
C
$600,000
6%
8%
5 years
a.
Compute the proceeds of each bond.
b.
c.
Will the BS value increase, decrease, or remain constant over life of bond?
Will the interest expense increase, decrease, or remain constant over life of
bond?
E11-11 Bonds
Interest payments are made semi-annually on these bonds:
Bond
Issuance
Face Value
Stated
Interest Rate
Effective
Interest Rate
Life
A
$110,000
6%
6%
10 years
B
$400,000
8%
6%
10 years
C
$600,000
6%
8%
5 years
a.
Compute the proceeds of each bond.
b.
c.
Will the BS value increase, decrease, or remain constant over life of bond?
Will the interest expense increase, decrease, or remain constant over life of
bond?
Sample Problem 2: Bonds Payable issued at Premium,
semiannual interest payments
• On July 1, 2007, Mustang Corporation issues $100,000
of its 5-year bonds which have an annual stated rate of
7%, and pay interest semiannually each June 30 and
December 31, starting December 31, 2007. The bonds
were issued to yield 6% annually.
• Calculate the issue price of the bond:
(1) What are the cash flows and factors?
Face value at maturity = $100,000
Stated Interest =
Face value x stated rate x time period
100,000 x 7% x (1/2) = $3,500
Number of periods = n = 5 years x 2 = 10
Discount rate = 6% / 2 = 3% per period
Sample Problem 2 - calculations
PV of interest annuity:
PVOA Table
PVOA = 3,500 (8.53020) = $29,856
i = 3%, n = 10
PV of face value:
PV1 Table
PV = 100,000 (0.74409)=$74,409
i=3%, n=10
Total issue price =
$104,265
Issued at a premium of $4,265 because the company
was offering an interest rate greater than the market
rate, and investors were willing to pay more for the
higher interest rate.
Sample Problem 2 - Amortization Schedule
To recognize interest expense using the effective interest
method, an amortization schedule must be constructed.
(This expands the text discussion.)
To calculate the columns (see next slide):
Cash interest paid = Face x Stated Rate x Time
= 100,000 x 7% x 1/2 year = $3,500
(this is the same amount every period)
Int. Expense = CV x Market Rate x Time
at 12/31/07 = 104,265 x 6% x 1/2 year = 3,128
at 6/30/08 = 103,893 x 6% x 1/2 year = 3,117
The difference between cash paid and interest expense is the
periodic amortization of premium.
Note that the carrying value is amortized down to face value
by maturity.
Sample Problem 2 - Amortization Schedule
Date
7/01/07
12/31/07
6/30/08
12/31/08
6/30/09
12/31/09
6/30/10
12/31/10
6/30/11
12/31/11
6/30/12
Cash
Paid
3,500
3,500
3,500
3,500
3,500
3,500
3,500
3,500
3,500
3,500
Interest
Expense
3,128
3,117
3,105
3,093
3,081
3,069
3,056
3,042
3,029
3,015
Premium
372
383
395
407
419
431
444
458
471
485
Carrying
Value
104,265
103,893
103,510
103,115
102,708
102,289
101,858
101,414
100,956
100,485
100,000
Sample Problem 2 - Journal Entries
JE at 7/1/07 to issue the bonds:
Cash
104,265
Premium on B/P
4,265
Bonds Payable
100,000
JE at 12/31/07 to pay interest:
Interest Expense
Premium on B/P
Cash
3,128
372
3,500
Note that the numbers for each interest payment come
from the lines on the amortization schedule.
Sample Bonds Issued at Face Value
Sample Bonds Issued at a Discount
Sample Bond Amortization Table
Recap: Interest Bearing Notes and Bonds
>Issue date
>Pay interest and amortize discount or premium
>Maturity date
Investor’s Bond Yield= annual cash received/note price
“The yield on a 10 year note, which was
hovering at about 2.2% before the release of the
non-farm report [on Friday] plummeted to
about 2.07% in a matter of minutes. Yields,
which move in the opposite direction to prices,
continued to move lower, ending the day at
2.056%, compared with 2.173% late Thursday.”
Page B2, The Wall Street Journal, 4.7-8.2012
Bond Redemptions
When bonds are redeemed at the maturity date,
the issuing company simply pays cash to the
bondholders in the amount of the face value
and removes the bond payable from the
balance sheet.
To illustrate the redemption of a bond issuance
prior to maturity at a loss, assume that bonds
with a $100,000 face value and a $5,000
unamortized discount are redeemed for
$102,000. The $7,000 loss on redemption
would decrease net income
P11-10 Callable Bond Redemptions
12.31.14 account balances are:
Bond payable
$500,000
Premium on bond payable $ 12,600
The bonds have an annual stated rate of 8% and an effective rate
of 6%. Interest is paid 6.30 and 12.31.
a. Compute the gain or loss if the bonds are called for
104 on 1.1.2015?
P11-10 Callable Bond Redemptions
12.31.14 account balances are:
Bond payable
$500,000
Premium on bond payable $ 12,600
The bonds have an annual stated rate of 8% and an effective rate of 6%. Interest is paid
6.30 and 12.31.
b. Compute the gain or loss if the bonds are called for 108 on 1.1.2015?
c. Compute the gain or loss if the bonds are called for 110 on 7.1.2015?
Bond Conversions
The Jolly Corporation has $400,000 of 6 percent bonds outstanding. There is $20,000 of
unamortized discount remaining on these bonds after the July 1, 2015, semiannual interest
payment. The bonds are convertible at the rate of 20 shares of $5 par value common stock
for each $1,000 bond. On July 1, 2015, bondholders presented $300,000 of the bonds for
conversion.
1. Is there a gain or loss on conversion, and if so, how much is it?
2. How many shares of common stock are issued in exchange for the bonds?
3. In dollar amounts, how does this transaction affect the total liabilities and the total
stockholders' equity of the company? In your answer, show the effects on four accounts.
International Perspective
• The accounting disclosure requirements in non-U.S. countries
and IFRS are not as comprehensive as those in the United
States, partially because the information needs of the major
capital providers (i.e., banks) are satisfied in a relatively
straightforward way—through personal contact and direct
visits.
• A second way in which the heavy reliance on debt affects nonU.S. accounting systems is that the required disclosures and
regulations tend to be designed either to protect the creditor
or to help in the assessment of solvency.
Economic Consequences of Reporting
Long-Term Liabilities
• Improved credit ratings can lead to
lower borrowing costs
• Management has strong incentive to
manage the balance sheet by using
“off-balance-sheet financing” i.e.,
operating leases
Leases: operating or capital
• FASB issued SFAS No. 13, which requires certain leases
to be recorded as capital leases.
– Capital leases record the leased asset as a capital asset, and
reflect the present value of the related payment contract as a
liability.
• Requirements of SFAS No. 13 - record as capital lease for the
lessee if any one of the following is present in the lease:
– Title transfers at the end of the lease period,
– The lease contains a bargain purchase option,
– The lease life is at least 75% of the useful life of the asset, or
– The lessee pays for at least 90% of the fair market value of
the lease.
Capital Lease
P11-14 Capital and Operating Leases
Company leased equipment on 1.1.14 for an annual lease payment of $30,000.
Assume the lease term is 5 years and the life of the equipment is also 5 years. If the
lease is treated as a capital lease, the FMV of the equipment is $119,781. The
straight line depreciation method is used to depreciate fixed assets. The effective
interest rate on the lease is 8%.
a. Compute rent expense for 2014-2018 if lease is treated as an operating lease.
b. Compute the amounts that would complete the table:
Date
BS Value
Leasehold
Obligation
Interest
Expense
Depreciation
Expense
Total
Expense
1.1.2014
12.31.2014
12.31.2015
12.31.2016
12.31.2017
12.31.2018
c.
Compare total expense over 5 years for the two methods and comment.