CHAPTER
10
Long-Term
Debt Financing
Learning Objective 1
Use present
value concepts
to measure
long-term
liabilities.
Define Long-Term Liabilities
Debts and other obligations that will not
be paid in cash or satisfied with other
assets or services within one year.
Notes payable
 Bonds payable
 Mortgages payable
 Lease payments
 Pension obligations

Accounting for
Long-Term Liabilities
Measurement and recording of long-term liabilities
are based on the time value of money concept.
Present value of $1 is
the value today of $1 to
be received or paid in
the future, given a
specific interest rate.
If money can earn 10% per year, $100 to be received 1 year
from now is approximately equal to $90.91 received today.
Present and Future
Value Tables
Present Value Table
Future Value Table
 Locate the number of
 Locate the number of
periods in the left column
and the interest rate in the
row at the top of the table.
 This intersection is the
factor representing the
present value of $1.
 Discounting—present
value amount is the
amount that could be paid
today to satisfy the
obligation.
periods in the left
column and the interest
rate in the row at the top
of the table.
 This intersection is the
factor representing the
future value of $1.
 Compounding—the
frequency with which
interest is added to the
principal.
Present Value
Present value of $100 paid in 5 years
discounted at 10 percent.
Today 1
2
3
4 Future
Discount at 10%
PV = $62.09
$100
Future Value
Future value of $100 today
compounded for 5 years at 10 percent.
Today 1
2
3
4 Future
Compound at 10%
$100
FV = $161.05
Value Table — Future Value
Joan invested $2,000 for 3 years at 12 percent,
compounded annually. Using the table below,
what is the future value of the $2,000?
Periods
6%
3
1.1910
4
1.2625
5
1.3382
6
1.4185
8%
1.2597
1.3605
1.4693
1.5869
10%
1.3310
1.4641
1.6105
1.7716
Future value = Amount x FV Factor
Future value = $2,000 x 1.4049
Future value = $2,809.80
12%
1.4049
1.5735
1.7623
1.9738
Value Table — Future Value
Joan invested $2,000 for 3 years at 12 percent,
compounded semiannually. Using the table
below, what is the future value of the $2,000?
Periods
6%
3
1.1910
4
1.2625
5
1.3382
6
1.4185
8%
1.2597
1.3605
1.4693
1.5869
10%
1.3310
1.4641
1.6105
1.7716
12%
1.4049
1.5735
1.7623
1.9738
Future value = Amount x FV Factor
Future value = $2,000 x 1.4185
Future value = $2,837
Computing the Interest Rate
Provide the Appropriate Formula.
Interest rate per compounding period =
Yearly interest rate
Compounding periods per year
Number of interest periods =
Compounding x Number
periods per year
of
years
Define Annuities
Annuity
A series of equal amounts to be
received or paid at the end of equal
time intervals.
Present Value of an Annuity
The value today of a series of
equally spaced, equal-amount
payments to be made or received
in the future given a specified
interest rate.
Value Tables — Annuity
Joan is paid $8,000 a year for 8 years at 10
percent interest per year. Using the table below,
what is the present value of the annuity?
Periods
6%
7
5.5824
8
6.2098
9
6.8017
10
7.3601
8%
5.2064
5.7466
6.2469
6.7101
10%
4.8684
5.3349
5.7590
6.1446
12%
4.5683
4.9676
5.3282
5.6502
Present value = Amount x PV Factor
Present value = $8,000 x 5.3349
Present value = $42,679.20
Learning Objective 2
Account for long-term
liabilities, including
notes payable and
mortgages payable.
Time Line of
Business Issues
+
–
Bond
Note
Payable
Mortgage
Payable
Bond
Choose
Issue
Pay
Amortize
Bond
Retire
Example: Interest-Bearing
Notes
On January 1, 2003, Silver Eagle Co. borrowed
$20,000 for 3 years at 12 percent interest. The
interest is payable on December 31 of each
year. What entries are necessary for 2003?
Jan. 1 Cash. . . . . . . . . . . . . . . . . 20,000
Note Payable . . . . . . .
20,000
Borrowed $20,000 for 3 years at 12%.
Dec. 31Interest Expense . . . .
2,400
Cash. . . . . . . . . . . . . .
2,400
Made interest payment ($20,000 x 0.12).
Example: Interest-Bearing
Notes
What entry is needed when Silver Eagle Co.
repays the loan on December 31, 2002?
Dec. 31Interest Expense . . . . . . . 2,400
Note Payable. . . . . . . . . . 20,000
Cash. . . . . . . . . . . . . .
22,400
Interest payment and repayment of loan.
What is a Mortgage Payable?
 A written promise to pay a stated amount of
money at one or more specified future dates.
 Secured by the pledging of certain assets,
usually real estate, as collateral.
 Generally requires periodic (usually
monthly) payments of principal plus interest.
Example: Mortgages Payable
On January 1, 2003, Blue Bird Corp. borrowed
$500,000 to acquire a new building. The building
was signed as collateral for the 30-year, 7 percent
loan. Payments of $3,326.51 are to be made
monthly. What are the January 2003 entries?
Jan. 1 Cash. . . . . . . . . . . . . . . 500,000
Mortgage Payable. .
500,000
Borrowed $500,000 to purchase building.
Jan. 31 Mortgage Payable . . . .
409.84
Interest Expense . . . . . 2,916.67
Cash. . . . . . . . . . . .
3,326.51
Made first month’s mortgage payment.
Mortgages Payable
A mortgage amortization schedule shows
the breakdown between interest and
principal for each payment over the life
of a mortgage.
Month
1
2
3
4
5
6
Monthly
Payment
3,326.51
3,326.51
3,326.51
3,326.51
3,326.51
3,326.51
Principal
Paid
409.84
412.23
414.64
417.06
419.49
421.94
Interest
Paid
2,916.67
2,914.28
2,911.87
2,909.45
2,907.02
2,904.57
Mortgage
Balance
499,590.16
499,177.93
498,763.29
498,346.23
497,926.74
497,504.80
Learning Objective 3
Account for capital
lease obligations and
understand the
significance of
operating leases
being excluded from
the balance sheet.
Lease Obligations
Match the Following Terms.
Lessor
Operating
Lease
Lease
Lessee
Capital
Lease
1. The party that is granted the right to use
property under the terms of a lease.
2. The owner of property that is rented
(leased) to another party.
3. A simple short-term rental agreement.
4. A leasing transaction that is recorded
as a purchase by the lessee.
5. A contract that specifies the terms
under which the owner of an asset
agrees to transfer the right to use the
asset to another party.
YES
Classifying Leases
If the lease is cancelable or does not meet any of
the four requirements, is it an operating lease?
Yes
Transfer of Ownership?
Yes
No
Term  75% of
Useful Life?
No
Yes
Capital
Lease
No
Bargain Purchase
Option?
Yes
No
PV Payment 90%
of FMV?
Operating
Lease
Example: Lease Obligations
On January 1, 2003, The Cockatoo Company leased a
computer. The lease requires annual payments of
$5,000 for 8 years. The applicable interest rate is 12
percent. How is the lease recorded? What is the
December 31, 2003 entry for interest expense?
Jan. 1 Leased Computer . . . . . . .24,838
Lease Liability . . . . . . .
24,838
Leased a computer for company use.
Dec. 31 Lease Liability . . . . . . . . . . 2,019
Interest Expense . . . . . . . . 2,981
Cash. . . . . . . . . . . . . . . 5,000
Paid annual lease payment for computer.
Learning Objective 4
Account for bonds,
including the original
issuance, the payment
of interest, and the
retirement of bonds.
Define These Types of Bonds
Bond
A contract between a borrower (issuer) and a lender
(investor). The borrower promises to pay a specified
amount of interest for each period the bond is
outstanding and to repay the principal at the maturity
date.
Unsecured Bonds (Debentures)
Bonds for which no collateral has been pledged.
Secured Bonds
Bonds for which assets have been pledged in order to
guarantee repayment.
Coupon (Bearer) Bonds
Unregistered bonds for which owners receive periodic
interest payments by clipping a coupon from the bond
and sending it to the issuer as evidence of ownership.
Types of
Bonds
Matching
1. Bonds that mature in one lump
sum on a specified future date.
Serial Bonds
2.
Convertible Bonds
4.
Term Bonds
Callable Bonds
Registered Bonds
1.
3.
5.
2. Bonds that mature in a series of
installments at specified future
dates.
3. Bonds for which the issuer
reserves the right to pay the
obligation before its maturity
date.
4. Bonds that can be traded for, or
converted to, other securities
after a specified period of time.
5. The names and addresses of the
bondholders are kept on file by
the issuing company.
Types of Bonds
Zero-Coupon Bonds
Bonds issued with no promise of interest
payments; only a lump sum payment will be
made.
Junk Bonds
Bonds issued by companies in weak financial
condition with large amounts of debt already
outstanding; these bonds yield high rates of
return because of high risk.
Characteristics of Bonds
Match Correctly.
Principal (face value
or market value)
contract between
between aa bond
bond issuer
issuer
AAcontract
and
anda abond
bondpurchaser
purchaserthat
that
specifies
specifiesthe
theterms
termsofofa abond.
bond.
Bond Maturity Date
The amount
amount that
that will
will be
be paid
paid on
on aa
The
bond
bondatatthe
thematurity
maturitydate.
date.
Bond Indenture
The date
date at
at which
which aa bond
bond principal
The
principal
face amount
or face or
amount
becomes
becomes
payable.payable.
Determining Issuance Price
Price should equal:
present value of the interest payments
+
present value of the bond’s lump-sum face value at
maturity
Market rate (effective rate or yield rate) of
interest
The interest rate investors expect to earn on their
investment.
Stated rate of interest
The rate of interest printed on the bond.
Determining Issuance Price
Correctly Define Each Term.
Face Value
The amount that will be paid on a bond at the maturity
date.
Bond Discount
The difference between the face value and the sales
price when bonds are sold below their face value.
Bond Premium
The difference between the face value and the sales
price when bonds are sold above their face value.
Characteristics of Bonds
Bond
Stated
Interest
Rate
10%
Market Rate
Bond Sold at
8%
Premium
10%
Face Value
12%
Discount
Example: Bond Issued at Face
Value
Falcon Company agreed to issue 5-year,
$500,000 bonds and pay 10 percent
interest, compounded semiannually.
Assume the effective and stated rates are
equal. Calculate the issue price.
1. Semiannual interest payments $ 25,000
Present value of interest annuity
2. Maturity value of bonds
Present value of bonds
3. Issuance price of bonds
$193,043
$500,000
306,957
$500,000
Example: Bond Issued
at a Discount
Falcon Company agreed to issue 5-year,
$500,000 bonds and pay 10 percent
interest, compounded semiannually.
Assume the effective rate is 12 percent.
Calculate the issue price of the bonds.
1. Semiannual interest payments $ 25,000
Present value of interest annuity
2. Maturity value of bonds
Present value of bonds
3. Issuance price of bonds
$184,002
$500,000
279,197
$463,199
Example: Bond Issued
at a Premium
Falcon Company agreed to issue 5-year,
$500,000 bonds and pay 10 percent
interest, compounded semiannually.
Assume the effective rate is 8 percent.
Calculate the issue price of the bonds.
1. Semiannual interest payments $ 25,000
Present value of interest annuity
2. Maturity value of bonds
Present value of bonds
3. Issuance price of bonds
$202,772
$500,000
337,782
$540,554
Example: Accounting for
Bonds Payable
On January 1, 2003, Falcon Company
agreed to issue 5-year, $500,000 bonds
and pay 10 percent interest, compounded
semiannually. Assume the effective rate is
10 percent. What entry is needed to
record the liability?
Jan. 1 Cash . . . . . . . . . . . . . . . . 500,000
Bonds Payable. . . . . . .
500,000
Issued $500,000, 10%, 5-year bonds.
Example: Accounting for
Bonds Payable
On January 1, 2003, Falcon Company
agreed to issue 5-year, $500,000 bonds and
pay 10 percent interest, compounded
semiannually. Assume the effective rate is
10 percent. What entry is needed to record
the first interest payment?
Jun. 30 Bond Interest Expense . . 25,000
Cash. . . . . . . . . . . . . .
25,000
Paid interest ($500,000 x 0.10 x 0.5).
Example: Bond Retirements
at Maturity
On January 1, 2003, Falcon Company agreed
to issue 5-year, $500,000 bonds and pay 10
percent interest, compounded semiannually.
Assume the effective rate is 10 percent.
What entry is needed to record the
retirement of the bond on January 1, 2008?
Jan. 1 Bond Interest Expense. . . . . 25,000
Bonds Payable. . . . . . . . . . . . 500,000
Cash. . . . . . . . . . . . . .
525,000
Retired 5-year, $500,000, 10% bonds; paid
interest ($500,000 x 0.10 x 0.5).
Example: Bond Retirements
Before Maturity
The Great Owl Company issued $200,000, 14
percent bonds, which are now selling for 107
and are callable at 110. The bonds were
issued at face value. If the company decides
to call the bonds, what entry is needed?
Jan. 1 Bonds Payable. . . . . . . . .200,000
Loss on Bond Retirement.20,000
Cash (200,000 x 1.10) .
220,000
Retired a callable bond at 110.
Learning Objective 5
Use debt-related ratios to
determine the degree of a
company’s financial leverage
and its ability to repay loans
Debt Ratio
Measures the amount of
assets supplied by lenders.
Total Liabilities
Total Assets
Debt-to-Equity Ratio
Measures the balance of funds
being provided by creditors and
stockholders
Total Liabilities
Total stockholders’ equity
Times Interest Earned Ratio
The ratio of
income that is
available for
interest payments
to the annual
interest expense.
Income before interest
and taxes (operating profit)
Annual interest expense
Expanded Material
Learning Objective 6
Amortize bond
discounts and bond
premiums using either
the straight-line
method or the
effective-interest
method.
Define the Two Bond
Premium/Discount Amortization
Methods
Straight-line Method
A method of systematically writing
off a bond premium or discount,
resulting in equal amounts being
amortized each period.
Effective-interest Method
A method of systematically writing
off a bond premium or discount,
taking into consideration the time
value of money.
Which
method is
preferred by
GAAP?
GAAP prefers
the effectiveinterest method.
Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$196,000 for the bonds. Make the entry to
record the issuance of the bonds.
Jan. 1 Cash. . . . . . . . . . . . . . . . . 196,000
Discount on Bonds. . . . . . 4,000
Bonds Payable . . . . . . .
200,000
Issued $200,000 at a discount.
Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. Using straight-line
amortization, what entry is made for the
interest payment on June 30, 2003?
Jun. 30 Bond Interest Expense . . .10,200
Discount on Bonds. . . .
200
Cash. . . . . . . . . . . . . . .
10,000
Paid interest ($200,000 x 0.10 x 0.5).
Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. Using straight-line
amortization, what adjusting entry is
needed on December 31, 2003?
Dec. 31Bond Interest Expense . . .10,200
Discount on Bonds. . . .
200
Bond Interest Payable .
10,000
To recognize interest expense for 6
months.
Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. What entry is necessary to
retire the debt after 10 years?
Jan. 1 Bonds Payable. . . . . . . . . . 200,000
Cash . . . . . . . . . . . . . . .
200,000
Retired a $200,000, 10-year, 10% bond.
Example: Bond Issued
at a Premium
On January 1, 2003, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. Make the entry to
record the issuance of the bonds.
Jan. 1 Cash. . . . . . . . . . . . . . . . . 210,000
Premium on Bonds. . .
10,000
Bonds Payable . . . . . . .
200,000
Issued $200,000 at a premium.
Example: Bond Issued
at a Premium
On January 1, 2003, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. Using straightline amortization, what entry is made for
the interest payment on June 30, 2003?
Jun. 30 Bond Interest Expense. . . 9,500
Premium on Bonds. . . . . .
500
Cash . . . . . . . . . . . . . .
10,000
Paid interest ($200,000 x 0.10 x 0.5).
Example: Bond Issued
at a Premium
On January 1, 2000, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. Using straight-line
amortization, what entry is needed on
December 31, 2000?
Dec. 31
Bond Interest Expense. . . .9,500
Premium on Bonds. . . . . . .500
Bond Interest Expense .
10,000
To recognize interest expense for 6 months.
Example: Bond Issued
at a Premium
On January 1, 2003, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. What entry is
necessary to retire the debt after 10 years?
Jan. 1 Bonds Payable. . . . . . . . . .200,000
Cash . . . . . . . . . . . . . .
200,000
Retired a $200,000, 10-year, 10% bond.
Example: Effective-Interest Method
The Woodpecker Company issued a $1,000, 8
percent bond. The market rate was 7 percent at
the time of issuance. Create an effectiveinterest table.
A
B
(1,000 x 0.04) (E x 0.035)
#
C
D
E
(A-B)
(D-C)
(1,000+D)
Premium Unamortized Bond
Interest
Book
Payment Expense Amortization Premium
$71.00 $1,071.00
1
$40.00
$37.49
$2.51
68.49
1,068.49
2
40.00
37.40
2.60
65.89
1,065.89
3
40.00
37.31
2.69
63.20
1,063.20