Chapter 9
Liabilities: Introduction
BUS 780
Objectives of the Chapter
1. To learn the basic concepts of liabilities
and liability recognition.
2. To learn accounting for current liabilities,
including estimated and contingent
liabilities.
3. To learn accounting for long-term
liabilities (i.e., issuance of bonds for
cash).
Liabilities: Introduction
2
Objectives of the Chapter (contd.)
4. To study the accounting procedures for
interest payments of bonds and the
amortization of bond discount or
premium.
5. To study the accounting procedures for
debt retirements either at or before
maturity.
6. To learn the accounting for issuance of
long-term note for assets or cash.
Liabilities: Introduction
3
1. Liabilities


Legal obligations require future
payments of cash or services or the
creation of other liabilities as a result of
past transactions.
Recognition principle: accrual basis
(i.e., A liability should be recognized
when it occurs, not when it is paid.)
Liabilities: Introduction
4
The Importance of Understanding the
GAAP’s Definition of a Liability



Lenders often require the borrowers to keep
debt/equity under a specific level (i.e., not
more than 50%) in the loan agreement.
If the ratio is greater than the constraint, the
lender may have additional rights, such as to
charge a higher interest rate.
Investors (creditors) often use the
debt/equity ratio to make their credit
decisions.
Liabilities: Introduction
5
Off-Balance Sheet Liabilities



When calculating the debt/equity ratio,
attention should be given to the off-balance
sheet liabilities which are obligations not
reported as liabilities on the balance sheet
and only disclosed in the footnotes.
Examples: operating lease obligations,
pension liabilities, SPE’s liabilities
guaranteed by the corporation/sponsor, etc.
Off-balance liabilities will be discussed in
chapter 10.
Liabilities: Introduction
6
2. Current Liabilities


Obligations must be fulfilled in one year or
one operating cycle, whichever is longer.
Examples of current liabilities as a result of a
business transaction: (with definite amount)
 A/P (accounts payable)
 N/P (notes payable)
 Current maturity portion of a long-term
debt (i.e., bonds payable)
 Sales taxes payable
 Payroll taxes withholdings
Liabilities: Introduction
7
Employee Related Liabilities: FICA, Federal
I/T, state I/T, Medical Insurance Premiums…
i.e.
Salaries Expense
50,000
Employee F.I.C.A. Taxes Payable*
3,825
Federal I/T Payable
10,000
State I/T Payable
2,500
Salaries Payable
32,675
*0.0765 * 50,000
Liabilities: Introduction
8
Employee Related Liabilities (contd.)

Employer payroll taxes:
Payroll Taxes Expense
6,925
Employer F.I.C.A. Taxes Payable
3,825
F.U.T.A. Taxes Payablea
400
State Unemployment Tax Payableb 2,700
a. 6.2% of the first $7,000 of salaries paid to
employees.
b. assuming a state unemployment tax = 5.4%.
Liabilities: Introduction
9
Other Current Liabilities (with definite
amount)


Refundable Deposits
Cash
Refund Deposit Liabilities
xxx
xxx
Unearned Revenue (i.e., subscription fees
received in advance, advances from
customers before delivery, etc.)
Cash xxx
Unearned Subscription Revenue xxx
(or Advances from Customers)
Liabilities: Introduction
10
Accrued Liabilities

Obligations accumulated on a daily basis
but not recorded until the end of period
through adjusting entries (i.e., Interest
payable, salaries payable, rent payable…)
J. E. Interest Expense
xxx
Interest Payable
Liabilities: Introduction
xxx
11
Estimated Liabilities

Liabilities exist but the amount is
unknown, i.e.,

Property taxes

Warranty obligations

Coupon and premium obligations

Vacation Wage and Fringes Payable
Liabilities: Introduction
12
Expense Warranty Using Accrued
Method
(for financial Reporting Purposes)

Estimate the warranty expense
associated with the sales during the
period at the end of the period and
recognize it.
Liabilities: Introduction
13
Expense Warranty Using Accrued
Method (contd.)

Journal Entry:
Warranty Expense
Estimated Warranty Liability
When warranty services provided:
Estimated warranty liability
Cash (or Inventory)
xxx
xxx
xxx
xxx
If the estimated warranty liabilities are not enough
to cover the current year’s warranty services,
additional warranty expense would be debited.
Liabilities: Introduction
14
Premiums and Coupons
Obligations


Liabilities of premiums and coupons should
be estimated and recognized in the year when
sales are made.
Journal Entry
Premium (or Coupon) Expense
xxx
Estimated Premium Claims
(or coupon) outstanding
Liabilities: Introduction
xxx
15
Premiums and Coupons
Obligations (contd.)

When premiums (or coupons) are claimed:
Journal Entry
Estimated Premium Claims
(coupon) outstanding
xxx
Inventory
xxx
* If the actual redemption of coupons (or
premiums) is greater than the estimated
liabilities, the underestimated amount would be
recognized as the expense of the current year.
(APB 20)
Liabilities: Introduction
16
Contingencies

Contingent Liabilities

Contingent Losses

Contingent Gains
Liabilities: Introduction
17
Contingent Liabilities

Obligations may arise because of the
occurrence or not occurrence of future
event(s). (i.e., warranty obligations)
Liabilities: Introduction
18
Contingent Losses and Gains

Losses (gains) may arise because of
the occurrence or not occurrence of
future event(s).
(i.e., the uncollectable accounts, the
pending lawsuit losses (gains), possible
damage of a fire, etc.…)
Liabilities: Introduction
19
Accounting Treatments of
Contingencies


The accounting treatments of the
contingencies depend on the occurrence
probability of the related future
event(s).(FASB No. 5)
If the future event is
a. Probable, and
b. amount of liability can be reasonable
estimated.
The liability should be estimated, and
recognized on the balance sheet.
Liabilities: Introduction
20
Accounting Treatments of
Contingencies (contd.)



Probable: defined by the FASB as “the
future event(s) is(are) likely to occur”; no
specific % is given.
Common practice of probable by
accountants: probability of occurrence is
between 80% to 85%.
IASC: Probable is defined as “more likely
than not” .
Liabilities: Introduction
21
Accounting Treatments of
Contingencies (contd.)

Examples:
1. Bad Debt Expenses
Allowance for Bad Debt
xxx
xxx
2. Warranty Expense
xxx
Estimated Warranty Liabilities
xxx
3. Lawsuit Expenses
xxx
Estimate Liability under litigation xxx
Liabilities: Introduction
22
Accounting Treatments of
Contingencies (contd.)


If the future event is probable, but the
amount of loss/liability cannot be estimated,
the contingent loss/liability should be
disclosed (i.e., Merck’s disclosure of Vioxx
lawsuits).
Contingent gains:
 No unrealized gain can be recognized
under the current accounting standards
(conservatism!!!)
Liabilities: Introduction
23
3. Long-Term Liabilities





Issuance of bonds (at a premium or
discount)- cash inflow
Issuance of bonds between interest
payment dates
Extinguishment of debt – cash outflow
Convertible Bonds, callable bonds
Mortgage payable and Long-term Notes
Payable
Liabilities: Introduction
24
Present Value of $1


Present value concept:
Present value of $1 is the value today of $1 to be
received in the future, given a specific interest
rate.
Example:
1. What is the present value of $100 to be received
a year from now given an annual market interest
rate of 10%?
P.V.  (1+10%) = $100
P.V. = $100/1.1
= $100  0.9091
= $90.91
Liabilities: Introduction
25
Present Value (contd.)
2. What is the present value of $100 to be received
two years from now given an annual interest rate of
10%?
P.V  (1+10%)  (1+10%) = $100
P.V  (1+10%)2 = $100
P.V.  1.21 = $100
P.V.
= $100 / 1.21
= $100  0.8264
= $82.64
Liabilities: Introduction
26
An Ordinary Annuity:

Receiving (or paying)a constant amount of
money at the end of each period (equal time
internal) for a given number of periods
$100
$100
$100
$100
$100
1 year

What is the present value of receiving $100
every year for the following 5 years starting a
year from now? Liabilities: Introduction
27
The Present Value of an Ordinary
Annuity:
1. Using the example above given a10% Interest rate:
P.V. of the first $100 = $100  0.9091 = $90.91
P.V. of the second $100 =
$100  0.8264 = $82.64
P.V. of the third $100 =
$100  0.7513 = $75.13
P.V. of the fourth $100 =
$100  0.6830 = $68.30
P.V. of the fifth $100 =
$100  0.6209 = $62.09
Total
3.7907 $379.07
Liabilities: Introduction
28
Present Value (P.V.) of an Annuity
(contd.):



The P.V. of $100 annuity receiving
every year for the following 5 years,
starting a year from now =>
$100 * 3.7907 = $379.07
The P.V. of this annuity can be obtained
from an annuity table under 10%, 5
periods.
Liabilities: Introduction
29
Present Value (P.V.) of an Annuity
(contd.):
2. What is the P.V. of $300 annuity receiving
every 6 months for the following 30
months, starting 6 months from now ? The
annual interest rate is 12%.
P.V. = $300 x 4.2124 = 1,263.7
Annuity Table, 5 periods at 6%
(30/6=5)
(12%/2=6%)
Liabilities: Introduction
30
Corporate Bonds:



Bonds are securities issued by a
corporation to borrow money from the
public (i.e., from many
lenders/investors).
This is a source to raise funds.
The corporation will receive cash when
bonds are issued.
Liabilities: Introduction
31
Corporate Bonds:


The face value of the bonds must be
repaid to the bondholders on the
maturity date of the bonds.
Also, the bond issuers (the borrower)
will have to pay interests to the
bondholders (the lender/investor)
periodically (i.e., semi-annually).
Liabilities: Introduction
32
Bonds Payable


Long-Term Liability: if bonds mature in
more than one year.
Short-Term Liability: if bonds mature in
less than one year
Liabilities: Introduction
33
Bonds Payable (contd.)


Bond Indenture is an agreement States the
following:
Interest rate of bonds;
Interest Payment dates;
The maturity date of bonds;
 The type of bonds: callable, convertible,..
The indenture is held by a trustee appointed
by the issuing firm to represent the rights of
the bondholders.
Liabilities: Introduction
34
The Process of Bond Issuance
1. Receive the approval from the
stockholders and regulatory authorities
(i.e., the SEC).
2. Print bond certificates and write indenture
(to set the terms of bond issue such as the
stated interest rate, the interest payment
date and the maturity date…)
3. Make a public announcement of its intent
to sell the bonds on a particular date.
Liabilities: Introduction
35
The Process of Bond Issuance (cont.)
4. Negotiate the appropriate selling price
with the underwriters based on the terms
of bond issue (i.e., the stated inters rate),
the general bond market conditions, the
risk of the bonds and the expected state
of the economy.
Liabilities: Introduction
36
The Process of Bond Issuance (cont.)
5. The underwriter will determine the
effective interest rate (yield) and thus,
the selling price that it believes best
reflects the current market condition and
the risk the bond for a particular bond
issue.
6. The underwriter will either purchase the
bonds from the issuing company and
resell them to the public or sell these
bonds for a commission.
Liabilities: Introduction
37
The Process of Bond Issuance (cont.)


Companies can sell the entire issue of
bonds to an underwriter or sell it to a single
investor (i.e., a pension fund) (referred to
as a private placement).
Any expenditures connected with a bond
issue (legal fee, printing costs, accounting
fee, underwriter's charges …) should be
deferred and amortized as expense over
the life of the bond using a straight line
method.
Liabilities: Introduction
38
The Process of Bond Issuance (Contd.)




The yield is the market rate (effective rate) for
the bond issue.
The yield is often different from the stated
interest rate as a result of :
1) different opinion between the underwriter
and the company, or
2) a change in the economic conditions
between the date the terms were set and the
date the bonds were issued.
Liabilities: Introduction
39
The Process of Bond Issuance (Contd.)
Three possible outcomes of bond issuance:
1. Stated rate = effective rate (yield)
=> the bonds are sold at par
2. Stated rate < effective rate
=> bonds are sold at discount
3. Stated rate > effective rate
=> bonds are sold at premium
Liabilities: Introduction
40
Units of bonds:
At $1,000 denominations or a multiple of
$1,000.


Price of bonds: stated at 100s

Example: $1,000 issued at 98
The issuing price is $1,000  98 =
$980

Liabilities: Introduction
41
Types of bonds:
On the basis whether the bonds are secured:

Secured Bonds

Unsecured Bonds (Debentures)
On the basis of how the interests are paid:

Registered Bonds

Coupon Bonds
Liabilities: Introduction
42
Types of bonds:
On the basis of how the bonds mature:

Term Bonds

Serial Bonds

Convertible Bonds

Callable Bonds
Liabilities: Introduction
43
Determination of Bond Price

The obligations of bond issuers:
(1) to pay the principal when bond
matures on the maturity date.
(2) to pay interests periodically (i.e.,
semiannually) over the life the bond.
Liabilities: Introduction
44
Determination of Bond Price (Contd.)


Bond Price: the present value of the
bond.
Present value of bonds => The sum of
(1) the present value of the principal plus
(2) the present value of the periodic
interests (an annuity).
Liabilities: Introduction
45
Determination of Bond Price (Contd.)


Discount rate = effective rate = market
rate =yield
 This rate depends on the riskiness
of the issuer, the general state of
the economy, the duration of the
bond, etc.
In general, a higher risk will result in a
higher effective rate.
Liabilities: Introduction
46
Determination of Bond Price (Contd.)

Bonds Issued at Face Value
When the stated interest rate equals the
effective interest rate, the bond price
will equal the face value.
Liabilities: Introduction
47
Determination of Bond Price (Contd.)
Example 1:
Page company issued a 5-year term bond
with a face amount $100,000 and a stated
annual interest rate of 10%.
Interests are paid semiannually.
Assume that the annual effective interest
rate demanded by investors for bonds of
this level of risk is also 10%, what is the
present value of the bond (the bond
price)?

Liabilities: Introduction
48
Determination of Bond Price (Contd.)
Example 1:
Page company issued a 5-year term bond
with a face amount $100,000 and a stated
annual interest rate of 10%.
Interests are paid semiannually.
Assume that the annual effective interest
rate demanded by investors for bonds of
this level of risk is also 10%, what is the
present value of the bond (the bond
price)?

Liabilities: Introduction
49
Determination of Bond Price (Contd.)
(1)P.V. of the principal ($100,000 mature in 5
years, discount rate 5%, 10 periods):
$100,000  0.6139 = $61,390
(2)P.V. of the interests received semiannually
for 10 periods (annuity, discount rate = 5%,
10 periods)
$5,000  7.7217 = 38,608.5
annuity table, 5%, 10periods
Liabilities: Introduction
50
Determination of Bond Price (Contd.)

The P.V. of the bond = the sum of (1) and (2)
= $61,390 + 38,608.5 = $100,000

Therefore, when the stated rate equals the
effective rate (the discount rate), the bond
price (the P.V. of bonds) equals the face
value.
Liabilities: Introduction
51
Determination of Bond Price (Contd.)

Therefore, when the stated rate equals the
effective rate (the discount rate), the bond
price (the P.V. of bonds) equals the face
value.
J.E. (when bonds are issued at face value)
Cash
100,000
Bonds payable
100,000
Liabilities: Introduction
52
Determination of Bond Price (Contd.)

Question:
What’s is the total interest expense of the
bond (issued at face value)?
Cash payments by the issuer*
($150,000)
Cash Rece. from issuing bonds $100,000
Interest Expense
($50,000)
* Principal on maturity date + semiannual interest payments
= $100,000 + $5,000 x 10 = $150,000
Liabilities: Introduction
53
Bond Issued at A Discount


When the stated interest rate is less than
the effective interest rate, the present
value of a bond will be less than its face
value.
Example 2: Use the same information as
in Example 1, except that the effective
rate is 12%, rather than 10% to compute
the present value of the bond.
Liabilities: Introduction
54
Bond Issued at A Discount (Contd.)

Since the interests are paid semiannually, the
discount rate is 6% with 10 periods.
(1)P.V. of the principal = $100,000 .5584 = $55,840

P.V. table, 6%, 10periods
(2) P.V. of the semiannual interest:
$5,000  7.3601 = 36,800.5

Annuity table, 6%, 10periods
P.V. of the bond = (1) + (2)
$55,840 + 36,800.5 = $92,640.5
Liabilities: Introduction
55
Bond Issued at A Discount (Contd.)

$92,640.5 < $100,000 (Discount = $7359.5)
P.V. of bond < Face vale
=> when the stated rate is less than the effective
rate (i.e., 10% < 12%), the P.V. of the bond will
be less than the face value.

J.E. (when bonds are issued at discount)
Cash
92,640.5
Discount on Bonds
7,359.5
Bonds Payable
100,000
Liabilities: Introduction
56
Bond Issued at A Discount (Contd.)
Question:
What is the total interest expense of this bond
(issued at Discount)?
Cash payment by the
issuer
($150,000)
Cash received from issuing
the bond (at Discount)
92,640.5
Interest Expense
$57,359.50*

Discount would increase the actual interest expense and needs to be
amortized over the life of the bond.
*Interest Expense
= interest payment + Discount
= $50,000 + 7,359.50 = $57,359.50
Liabilities: Introduction
57
Bond Issued at A Premium


When the stated interest rate is higher than
the effective interest rate demanded by the
investors for the level of the risk of the
bonds, the present value of the bonds would
be greater than its face value.
Example 3: use the same information as in
Example 1, except that the effective interest
rate is 8%. (the stated interest rate is still at
10%)
Liabilities: Introduction
58
Bond Issued at A Premium (Contd.)

Compute the P.V. of the bond:
Since the interests are paid
semiannually, the discount rate would
be 4% and the discounting periods are
10 periods.
(1) P.V. of the principal:
$100,000 x 0.6756 = $67,560
Liabilities: Introduction
59
Bond Issued at A Premium (Contd.)
(2) P.V. of the semiannual interest:
$5,000 x 8.1109 = $40,554.5
P.V. of the bond = (1) + (2)
= $67,560 + 40,554.5 = $108,114.5
$108,114.5 > $100,000 (Premium = 8,114.5)
Liabilities: Introduction
60
Bond Issued at A Premium (Contd.)
Example 3
J.E. (Bonds are issued at a Premium)
Cash
108,114.5
Bonds Payable
100,000
Premium on Bonds Payable
8,114.50

Liabilities: Introduction
61
Bond Issued at A Premium (Contd.)
Question: What is the total interest
expense of the bond (issued at
Premium)?
Cash payments by the issuer (150,000)
Cash received from
issuing the bond
108,114.5
Interest Expense
($41,885.5)
Liabilities: Introduction
62
Bond Issued at A Premium (Contd.)
Question: What is the total interest
expense of the bond (issued at
Premium)?
Cash payments by the issuer (150,000)
Cash received from
issuing the bond
108,114.5
Interest Expense
($41,885.5)
Note: Regardless of the market interest rate, the total
cash payments are the sample (i.e., $150,000) with
the same stated interest rate and same par value.
Liabilities: Introduction
63
Bond Issued at A Premium (Contd.)


A premium account: an adjunct account
to the bonds payable account and is
shown as an addition to the bonds
payable account.
A discount account: a contra account to
the bonds payable and is shown as a
deduction from the bonds payable.
Liabilities: Introduction
64
Bond Issued at A Premium (Contd.)


Book value (carrying value) of the bond
issued:
the face value plus any unamortized
premiums or minus any unamortized
discounts.
If an effective interest method is used to
amortize the discount (or premium), the
carrying value equals the present value
under the historical effective interest rate.
Liabilities: Introduction
65
4. Accounting for Bonds Payable - Bonds
Are Issued at A Discount







Information of example 2 is summarized below
with some additional information:
Stated Interest = 10% (annual)
Effective Interest = 12% (annual)
Date of Issuance = 1/1/x2 (sold on 1/1/x2)
Date of Maturity = 1/1/x7
Interest Payment Dates = 6/30 and 12/31
Face Value = $100,000
P.V. of the Bond = 92,640.50 (as computed
earlier)
Liabilities: Introduction
66
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)


Discount = $100,000 - 92,640.5 =
7,359.50
This discount would increase the interest
expense and would be amortized over
the life of the bond -5 year, 10 periods)
Liabilities: Introduction
67
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)

Amortization methods:
1. Straight-Line: the Discount would be
amortized equally over the life of the bond.
i.e., Amortization in 10 periods:
$7349.5010 = $735.95
Therefore, the interest expense every period
is
$5,000 + 7,35.95 = $5,735.95
Semiannual
Interest Payment
the amortized Discount
Liabilities: Introduction
68
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)

Total Interest expense
= 5,735.95 x 10 = $5,7359.5
= 50,000 + 7,359.5

Int. payment

Discount
2. Effective Interest Method
Interest Expense
= P.V. of Bond  effective rate
Liabilities: Introduction
69
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
J.E (Bonds are issued at a discount and use the
straight-line method to amortize the discount)
1/1/x2 Cash
92640.50
Discount on B/P
7359.50
B/P
100,000
6/30/x2 Interest Expense
5,736
Cash
5000*
Discount on B/P 735.95**
12/31/x2 Interest Expense
5,736
Cash
5,000
Discount on B/P
735.95

Liabilities: Introduction
70
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
12/31/x6 Interest Expense 5,736
Cash
5,000
Discount on Bonds Payable 735.95
1/1/x7 B/P
100,000
Cash
100,000
Discount on Bonds
1/1/x2 7,359.50
Interest Expense from
1/1/x2 to 12/31/x6
735.95 6/30/x2 = $ 5,735.95 * 10
735.95 12/31/x2 = $5,7,359.50
735.95 6/30/x3 = $50,000 + 7,359.5
735.95 12/31/x6 Interest
Discount on
payments Bonds
Liabilities: Introduction
71
Accounting for Bonds Payable -
Bonds
Are Issued at A Discount (Contd.)




J.E. for bonds issued at a discount and use the
effective interest method to amortize the
discount: using the example on p.48.
Interest Payment = $100,000 * 5%= $5,000
Interest Expense = P.V. of Bond at the
Beginning of the period  Effective Rate
Amortized Discount = Interest Expense Interest payment
Liabilities: Introduction
72
Effective Interest Amortization Tablebond are issued at a discount
1
Period
P.V at Beg.
Of Period
0
1
2
3
4
5
6
7
8
9
10
492,641
93,199
93,791
94,418
95,083
95,787
96,534
97,326
98,166
99,056
Total
2
Interest
Expense
(1) * 6%
$5,558
5,592
5,627
5,665
5,704
5,704
5,792
5,840
5,890
5,944
3
4
Cash
Amortized
(Interst)
Discount
payments (2) - (3)
$5,000
$558
$5,000
592
$5,000
627
$5,000
665
$5,000
704
$5,000
747
$5,000
792
$5,000
840
$5,000
890
$5,000
944
$57,359
$50,000
5
Unamortized
Discount
(5)-(4)
$7,359
$6,801
6,209
5,582
4,917
4,213
3,466
2,674
1,834
944
-
6
P.V. at end of
Period
$100,000 - (5)
$92,641
93,199
93,791
94,418
95,083
95,787
96,514
97,326
98,166
99,056
100,000
7,359
Liabilities: Introduction
73
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
J.E :
1/1/x2 Cash
Discount on B/P
B/P
6/30/x2 Interest Expense
(period 1)
Cash
Discount on B/P
12/31/x2 Interest Expense
(period 2)
Cash
Discount on B/P

92,641
7,359
100,000
5,558
5,000
558
5,592
5,000
592
Liabilities: Introduction
74
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
6/30/x3 Interest Expense
Cash
Discount on B/ P
:
:
6/30/x6 Interest Expense
Cash
Discount on B/P
12/31/x6 Interest Expense
Cash
Discount on B/P
1/1/x7 B/P
Cash
Liabilities: Introduction
5,672
5,000
672
5,890
5,000
890
5,944
5,000
944
100,000
100,000
75
Accounting for Bonds Payable - Bonds
Are Issued at A Discount (Contd.)
Discount on Bonds Payable Interest Expense over 10
1/1/x2 7,359
558…6/30/x2
periods =>
Period 1 $5,558
592…12/31/x2 Period 2 $5,592
672…6/30/x3 period 3 $5,627
890…6/30/x6
Period 9 $ 5,890
Period 10 $ 5,944
944…12/31/x6
0
$57,359
$57360= $50,000 + 7,359
Liabilities: Introduction
76
Accounting for Bonds Payable -Bonds Are
Issued at A Premium
Information of example 3 is summarized with some
additional information:
 Stated Interest Rate (annual) = 10%
 Effective Interest Rate (annual) = 8%
 Date of Issuance = 1/1/x2 (sold on 1/1/x2)
 Date of Maturity = 1/1/x7
 Interest Payment Date = 6/30 and 12/31
 Face Value = $100,000
 P.V. of the Bond = $108,115 (as computed earlier)
Liabilities: Introduction
77
Accounting for Bonds Payable-Bonds Are
Issued at A Premium



Premium = $108,114.5 - 100,000 = $8,114.5
The premium would decrease the interest expense
and should be amortized over the life (5 years, 10
periods) of the bond.
J.E. (Amortization Method= Straight-Line)
$8,114.5 / 10 = $8114.5 => $811.45 would be
amortized for every period. The interest expense
would be decreased by $816 every period.
1/1/x2 Cash
108,114.5
B/P
100,000
Premium on Bonds Payable
8,114.5
Liabilities: Introduction
78
Effective Interest Amortization Tablebond are issued at a premium
Period
0
1
2
3
4
5
6
7
8
9
10
Total
1
2
P.V. at Beg
of Period
Interst
Expense
(1) * 4%
108,114.50
107,440
106,738
106,008
103,248
104,458
103,636
102,781
101,892
100,965
4,325
4,298
4,270
4,240
4,210
4,178
4,145
4,111
4,076
4,039
41,885.50
3
Cash
Payments
100,000 x
5%
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
50,000
4
5
6
Amortizatied Unamortized P.V. at End
Premium
Premium
100,000 /
(3) - (2)
(5) - (4)
(5)
675
702
730
760
790
822
855
889
924
968*
8114.5
8,114.50
7,440
6,738
6,008
5,248
4,458
3,616
2,781
,892
968
0
Interest Expense = Cash payment - Amortized premium
= 50,000 - 8114.5
= 41,885.5
* Rounding Error of $ 7 (968-961 =Liabilities:
7)
Introduction
108114.5
107,440
106,738
106,008
108,248
104,458
103,636
102,781
101,892
100,968
100,000
79
Accounting for Bonds Payable (Contd.)
Premium on Bonds
6/30/x2…
675
12/31/x2 …
702
730
8114.5 …1/1/x2
Interest Expense over
10 periods =>
Period
$
760
1
4,325
790
2
4,298
822
4,270
855
889
924
10
968
41,885.50
0
Liabilities: Introduction
80
Accounting for Bonds Sold Between
Interest Payment Dates:

Policy of interest payment for bonds:
Interest
are always paid in full
regardless how long the bonds being
held by the bondholder.
Thus,
the bond issuing company
collects the accrued interests in
addition to the issuing price when
bonds are sold between interest
payment dates.
Liabilities: Introduction
81
Accounting for Bonds sold Between
Interest Payment Dates at Par:

Example: assume that on 2/1/x2, Page
company issued a 5- year term bond with
a face amount of $100,000 and a stated
interest rate of 10%. The bonds were
issued at Par and interests were paid
semiannually on 2/1 and 8/1. The bonds
were sold on 5/1/x2.
Liabilities: Introduction
82
Accounting for Bonds Sold Between
Interest Payment Dates at Par:

J.E. 5/1/x2 (bond sold at par on 5/1/x2)
Cash
Bonds Payable
Interest Payable*
102,500
100,000
2,500
* Accrued interest of 3 months (From 2/1 ~ 5/1)
8/1/x2 Interest Payable*
Interest Payable
Cash
2,500
2,500
5,000
* 100,000 x 10% x 6/12 = 5,000 (6 month interest)
Actual Interest Expense (from 5/1/x2 - 8/1/x2) =>
5,000 -2,500 = 2,500
Liabilities: Introduction
83
5. Bond Retirements Before Maturity

Use example 2 (issued at a discount), assume that
bonds are retired at the end of period 3 for $98,000
Discount on Bonds
7,359
558…..Period 1
592…..Period 2
627…..Period 3
5,582
Unamortized at the end of period 3
BV of the Bond = 100,000 - 5,582 = 94,418
Liabilities: Introduction
84
Bond Retirements Before Maturity
B/P
100,000
Loss on Retirement of Bonds
Discount on Bonds Payable
Cash
3,582
5,582
98,000
Liabilities: Introduction
85
6. Long-Term Notes Payable


APB Opinion No. 21 requires the longterm notes payable to be recorded at
their present values and the effective
interest method is used to record the
subsequent interest.
The effective interest rate (or implicit
rate) is the rate that equates the future
net cash flows to the present value.
Liabilities: Introduction
86
Long-Term Notes Payable (contd.)


Therefore, if the present value (p.v.)
and future net cash flows are known,
the effective interest can be calculated.
Also, if both the effective interest rate
and future net cash flows are known,
the present value can be calculated.
Liabilities: Introduction
87
Long-Term Notes Payable (contd.)

In other cases, when the P.V. is not
known, the incremental interest rate of
the borrower is used as the effective
rate to calculate the P.V. of the note.
Liabilities: Introduction
88
Long-Term Notes Payable (contd.)
A. Notes payable issued for cash:
When a long-term note is exchanged for
cash, the note is assumed to have a
present value equals the cash proceeds.
The difference between the cash
proceeds and the face value of the note
is recorded as a discount (or premium)
The discount (or premium) is amortized
over the life of the note using the effective
interest method.
Liabilities: Introduction
89
Example A

Johnson Company issued a 3-year, noninterest-bearing note with a face value of
$8,000 and received $5,694.24 in exchange.
The journal entry to record the issuance is:
Cash
Discount on
Notes Payable
Note Payable
5,694.24
2,305.76
Liabilities: Introduction
8,000
90
Example (contd.)

The discount account is a contra account to
notes payable. The effective interest rate
that equates the P.V. of 5,694.24 to $8,000
at the end of 3 years is 12%.
5,694.24 = 8,000 x 0.71178  3-period, 12%
Liabilities: Introduction
91
Example (contd.)
The Interest Expense Per Year is Computed as:
N/P
Less:
Unamortized
Discount
Carrying Value
(at beg.)
x Effective Rate
Interest
Expense
- Interest
Payment
Amortized
Discount
Year 1
8,000
Year 2
8,000
Year 3
8,000
(2,305.76)
(1,622.45)
(857.14)
5,694.24
6,377.55
7,142.86
12%
12%
12%
683.31
765.31
857.14
0
0
0
683.31
765.31
857.14
Liabilities: Introduction
92
Example (contd.)
Recognition of Interest Expense of Year 1:
Interest Expense
683.31
Discount on N/P
Cash
(non-interest bearing note)
Liabilities: Introduction
683.31
0
93
Notes Payable Exchanged for
Property, Goods, or Services


APB opinion No.21 requires the note be
recorded at the fair market value of the
property, goods, or services or the fair
market value of the note (I.e., the present
value of the note is known), whichever is
more reliable.
And, the effective interest rate is calculated
(when both the P.V. and future cash flows
are known) and used to calculate
subsequent interest expense using the
effective interest method.
Liabilities: Introduction
94
Notes Payable Exchanged for
Property, Goods, or Services (contd.)

If neither of these values is
determinable, the incremental
borrowing rate of the borrower is used
as the effective interest rate to calculate
the P.V. of the note and the interest
expense of subsequent years using the
effective interest method.
Liabilities: Introduction
95
Example B



On 1/1/x5, Marden Company purchases
an equipment by issuing a non-interestbearing 5-year note with a face value of
$10,000.
Neither the fair market value of the
equipment nor that of the note is
determinable.
The incremental borrowing rate of Marden
is 12%.
Liabilities: Introduction
96
Example (contd.)
J.E. 1/1/x5
Equipment
Discount on N/P
N/P
5,674.27*
4,325.73
10,000
* P.V. of the note using 12% as the effective interest
rate => 10,000 x 0.567427
Liabilities: Introduction
97
Example (contd.)
12/31/x5
Int. Exp. (5674.27 x 12%)
680.91
Discount on N/P
680.91
Depreciation Expense
567.43
Accumulated Depreciation
567.43
(Assuming a S-L depreciation method is used
and a 10-year life is assumed for the
equipment)
Liabilities: Introduction
98
Example (contd.)
12/31/x6
Int. Exp. (5,674.27 + 680.91) x 12%
762,62
Discount on N/P
Depreciation Expense
762.62
567.43
Accumulated Depreciation
Liabilities: Introduction
567.43
99
Example C

Using the Example B, except that the
fair market value the equipment was
determined at $6,209.21. The interest
rate that equates the future cash flows
to the present value of $6,209.21 is
10%.
Liabilities: Introduction
100
Example (contd.)
The following entries would be recorded for
20x5 and 20x6:
1/1/x5
Equipment
6,209.21
Discount on N/P
3,790.89
N/P
10,000
12/31/x5
Int. Exp. (6,209.21 x 10%)
621
Discount on N/P
621
12/31/x6
Int. Exp. (6,209.21 + 621) x 10% 683
Discount on N/P
683

Liabilities: Introduction
101
Example (contd.)

Regardless of the effective interest rate
on the long-term note payable, the total
expense (interest expense on the
unpaid portion of the note plus the
depreciation expense of the acquired
asset) charged by the company is the
same (i.e., $10,000).
Liabilities: Introduction
102
Installment Notes – Example D


Notes could be paid by installments (a
constant amount paid periodically) rather
than by a single amount at maturity.
Using Example B (on p95), assuming an
installment payment at the end of each
year for the following 5 years, ( starting
12/31/x5), the annual installment
payment for the note (loan) equals:
$6,209.21/ 3.79079=$1,638
Liabilities: Introduction
103
Installment Notes: (Contd.)

Journal Entries:
1/1/x5
Equipment
6,209.21
Note Payable
6,209.21
12/31/x5 Interest Exp. * 621
N/P
1,017
Cash
1,638
*6,209.21 x 10% = 621
12/31/x6 Interest Exp. * 519
N/P
1,119
Cash
1,638
*(6,209.21 - 1,017) x 10% = 519.2
Liabilities: Introduction
104
Installment Notes: (Contd.)

Journal Entries:
12/31/x7 Interest Exp. * 407
N/P
1,231
Cash
1,638
*(6,209-1,017-1,119) x 10% = 407
12/31/x8 Interest Exp. * 284
N/P
1,354
Cash
1,638
*(6,209-1,017-1,119-1,231) x 10% = 284
12/31/x9 Interest Exp. * 149
N/P
1,489
Cash
1,638
*(6,209-1,017-1,119-1,231- 1,354) x10% = 149
Liabilities: Introduction
105
Installment Notes: (Contd.)
N/P
1017
6209
1119
1231
1354
1489
0*
rounding error = $1
Liabilities: Introduction
106
Mortgage Payable
If the note of Example C was issued for
cash, it becomes a mortgage payable
example. The journal entries are as
follows:

Cash
6,209.21
Mortgage Payable 6,209.21
Liabilities: Introduction
107
Mortgage Payable (contd.)
12/31/x5 Interest Exp. * 621
Mortgage Pay.1,017
Cash
1,638
*6,209.21 x 10% = 621
12/31/x6 Interest Exp. * 519
M/P
1,119
Cash
1,638
*(6,209.21 - 1,017) x 10% = 519.2
Liabilities: Introduction
108
Installment Notes: (Contd.)


An installment note typically is recorded at
its carrying amount (i.e., the face amount
- the unamortized discount).
This is because the outstanding balance
of an installment does not become its face
amount as in the case for notes with a
single payment at maturity.
Liabilities: Introduction
109