Chapter 10
Long-Term Liabilities
Management Issues
Related to Issuing
Long-Term Debt
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10–1
Funding Growth
Growth usually requires investment in longterm assets and research and development
How do companies raise long-term funds?
Issuance of
capital stock
Issuance of
long-term debt
Take on long-term debt?
How much debt to carry?
What types of debt to incur?
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10–2
Deciding to Issue Long-Term Debt
Advantages to
consider
Disadvantages to consider
No loss of stockholder control A high level of debt exposes a
as when issuing stock
company to financial risk
The interest on debt is taxdeductible
If earnings on funds borrowed
do not exceed interest on debt,
If earnings on funds borrowed negative financial leverage is
experienced
exceed interest on debt,
financial leverage is gained
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10–3
Average Debt to Equity for
Selected Industries
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10–4
Evaluating Long-Term Debt
Many companies use the debt to equity ratio
when assessing how much debt to carry
Total Liabilitie s
Debt to Equity Ratio 
Total Stockholde rs’ Equity
$4,498.5  $9,613.4
McDonald’ s Debt to Equity Ratio 
 0.9
$15,279.8
McDonald’s also has long-term leases
that do not appear on the balance sheet,
called off-balance sheet financing.
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10–5
Off-Balance Sheet Financing
A legal way of structuring a lease commitment
so that it does not have to be included on the
balance sheet as a liability
Financial statement users
should review the notes to
the financial statements for
information about any
leases that may have the
effect of long-term
liabilities
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10–6
Interest Coverage Ratio
Measures how much risk a company is
undertaking with its long-term debt
Income Before Income Taxes  Interest Expense
Interest Coverage Ratio 
Interest Expense
Measures the degree of protection a company
has from default on interest payments
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10–7
Interest Coverage Ratio Illustrated
(hwk E 3)
McDonald’s 2007 annual report shows that the
company had income before income taxes of $3,572.1
million and interest expense of $410.1 million.
Income Before Taxes  Interest Expense
Interest Coverage Ratio 
Interest Expense
$3,572.1  $410.1

$410.1
 9.7 times
McDonald’s interest expense was covered 9.7 times in 2007. However,
management will add the company’s off-the-balance sheet rent expense of
$1,053.8 to its interest expense. This procedure decreases the coverage
ratio to less than 3.0 times, still adequate to cover interest payments.
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10–8
Types of Long-Term Debt
 Bonds payable
 Notes payable
 Mortgages payable
 Long-term leases
 Pensions
 Other postretirement
benefits
 Deferred income taxes
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10–9
Long-Term Debt
Bonds Payable
 Most common type of
long-term debt
 May be convertible to
common stock
 Involves a debt to many
creditors
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Notes Payable
 Represents a loan from a
bank or other creditor
Deutsche Telekom
International Finance
recently raised $14.6
billion by issuing a series
of long-term notes
denominated in dollars,
Euros, pounds, and yen.
10–10
Mortgages Payable
Long-term debt secured by real property. Usually repaid
in equal monthly installments that include interest on the
debt and a reduction in the initial debt.
Illustration: Monthly Payment Schedule on a $100,000, 12% mortgage
Payment Date
6/1
7/1
8/1
9/1
Unpaid Bal. At
Beg. of Period
$100,000
99,400
98,794
M onthly
Payment
$1,600
1,600
1,600
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Interest for 1
M onth at 1% on
Unpaid Bal.
$1,000
994
988
Reduction in Debt
Unpaid Bal. At
End of Period
$600
606
612
$100,000
99,400
98,794
98,182
10–11
Leases
• Companies may obtain an operating asset in
three ways:
Borrow the money and buy the asset
Rent the asset on a short-term lease (operating
lease; payments are treated as rent expense)
Obtain the asset on a long-term lease (may be
structured as a capital lease or an operating lease)
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10–12
Capital Leases
Accounting standards require
that a lease be treated as a
capital lease if the lease:
 Cannot be cancelled
 Has about the same
duration as the useful life
of the asset
 Stipulates that the lessee
has the option to buy the
asset at a nominal price
at the end of the lease
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Accounting for a
Capital Lease
The lessee should:
1) Record the asset
2) Record depreciation on
the asset
3) Record a liability equal to
the present value of the
total lease payments
during the lease term
10–13
Capital Lease Illustrated
Polany’s Manufacturing Company enters into a long-term
lease for a machine. The lease terms call for an annual
payment of $8,000 for six years, which approximates the
useful life of the machine. At the end of the lease period,
the title to the machine passes to Polany.
Use present value techniques to place a value on the asset and on the
corresponding liability. Assume that the interest cost on the unpaid part
of the obligation is 16 percent.
$8,000 x 3.685 = $29,480
Capital Lease Equipment
Capital Lease Obligations
To record capital lease on
machinery
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29,480
29,480
10–14
Capital Lease Illustrated
(hwk E5)
Each year, Polany must record depreciation on the leased asset. Assume
the company uses the straight-line method and no salvage value.
Depreciation Expense, Capital Lease Equipment
Accum. Depreciation, Capital Lease Equip.
To record depr. expense on capital
lease machinery
4,914
4,914
Polany must also record interest expense for the lease. The interest
expense for each year is computed by multiplying the interest rate by
the amount of remaining lease obligation.
Interest Expense
Capital Lease Obligations
Cash
Made payment on capital lease
$29,480 x 16% = $4,717
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4,717
3,283
8,000
10–15
Pension Liabilities
Pension plans
 Require a company to pay Employer
Employee
benefits to employees
contributions contributions
after they retire
 Some companies pay full
cost of pension plan
Pension Fund
 Employees often share the
cost of pension plans
Pension benefits paid to
retired employees
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10–16
Pension Plans
Defined Contribution Plan
Defined Benefit Plan
 Employer makes fixed, agreed-  Employer makes
upon, annual contribution
variable payments
 Retirement payments vary
required to fund the
depending on how much the
estimated future pension
fund earns
liability arising from
 Employees usually control their
current employment
own accounts and can transfer
 Retirement benefits are
funds if they leave the firm
fixed
 More complex
Examples: 401(K) plans, profitaccounting required
sharing plans, and ESOPs
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10–17
Other Postretirement Benefits
Retired employees may also be provided health care
benefits and other postretirement benefits
Recent accounting
 Estimates should account
standards hold
for retirement age, mortality,
postretirement benefits
future trends in health care
should be estimated and  Future benefits should be
expensed during the time
discounted to the current
that employees are
period
working in accordance
with the matching rule.
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10–18
Deferred Income Taxes
 Results from using different accounting methods to
calculate income taxes on the income statement and
income tax liability on the income tax return
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 A company might use
straight-line depreciation for
financial reporting and an
accelerated method for
income tax purposes. The
difference in taxes resulting
from the two methods is
listed as a long-term liability.
10–19
Bonds
A security, usually long term, representing money that
a corporation borrows from the investing public
Governments and foreign countries
also issue bonds to raise money
Must be repaid at
a specified time
and require
periodic payments
of interest at a
specified rate at
specified times
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10–20
What Is a Bond Issue?
A bond issue is the
total value of bonds
issued at one time
Prices of Bonds
• Stated in terms of a
percentage of face value
• Bonds selling at 100
• Sell at face or par value
For example, a
$1,000,000 bond issue
could consist of one
thousand, $1,000 bonds
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• Bonds selling above 100
• Sell at a premium
• Bonds selling below 100
• Sell at a discount
10–21
Selling Price of Bond Illustrated
A bond issue is quoted at 103 ½
What is the selling price of a $1,000 bond?
A bond issue quoted at 103 ½ means that the bond sells at 103.5
percent of its face value
Bond Selling Price  Face Value  Quoted Percentage of Face Value
 $1,000  1.035
 $1,035
This bond sells at a premium and would cost the buyer $1,035
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10–22
Interest Rates
 Face Interest Rate
 Market Interest Rate
Fixed rate of interest paid to
bondholders based on the
face value of the bonds
Rate of interest paid in the
market on bonds of similar
risk, also called the effective
interest rate
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10–23
Discounts and Premiums
Discount
• Equals the excess of
the face value over the
issue price.
• The issue price will be
less than the face value
when the market
interest rate is higher
than the face interest
rate.
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Premium
• Equals the excess of
the issue price over the
face value.
• The issue price will be
more than the face
value when the market
interest rate is lower
than the face interest
rate.
10–24
Bond Characteristics
(hwk P 2)
Issued on the basis of a firm’s general credit
Carry a pledge of certain corporate assets as a
Secured guarantee of repayment
Term
All bonds of an issue mature at the same time
Bonds of an issue mature on different dates
Serial
Gives issuer the right to buy back and retire the
Callable
bonds before maturity at a specified call price
Allows bondholder to exchange a bond for a
Convertible
specified number of shares of common stock
Registered Issued to a specific bondholder
Not registered with the organization
Coupon
Unsecured
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10–25
Issuing Bonds Payable
The board of directors must submit the appropriate
legal documents to the Securities and Exchange
Commission (SEC) for approval to issue bonds
 No journal entry is
required for the
authorization of the
bond issue (most
companies disclose
in the notes to the
financial
statements)
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10–26
Bonds Issued at Face Value
Bharath Corporation issues $200,000 of 9 percent, 5-year
bonds on January 1, 2010 and sells them on the same date
for their face value. The bond indenture states that interest
is to be paid on January 1 and July 1 of each year.
Jan. 1
Cash
200,000
Bonds Payable
Sold $200,000 of 9%, 5-year
bonds at face value
200,000
Record a semiannual interest payment:
Bond Interest Expense
Cash (Interest Payable)
Paid (or accrued) semiannual
interest to bondholders of 9%, 5year bonds
9,000
9,000
Interest  Principal  Rate  Time
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 $200,000  .09  6/12 year
 $9,000
10–27
Bonds Issued at a Discount
Bharath Corporation issues $200,000 of 9 percent, 5-year
bonds at 96.149 on January 1, 2010, when the market rate
is 10 percent.
Record the issuance of the bonds at a discount:
2010
Jan. 1
Cash
Unamortized Bond Discount
Bonds Payable
Sold $200,000 of 9%, 5-year
bonds at 96.149
Face amount of bonds
Less purchase price of bonds
($200,000 x .96149)
Unamortized bond discount
192,298
7,702
200,000
$200,000
192,298
$ 7,702
Unamortized Bond
Discount is a
contra-liability
account
Carrying Value of Bonds = Face Value – Unamortized Bond Discount
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10–28
Bonds Issued at a Premium
Bharath Corporation issues $200,000 of 9 percent, 5-year
bonds for $208,200 on January 1, 2010, when the market
rate is 8 percent.
Record the issuance of the bonds at a premium:
2010
Jan. 1
Cash
Unamortized Bond Premium
Bonds Payable
Sold $200,000 of 9%, 5-year
bonds at 104.1
($200,000 x 1.041)
208,200
8,200
200,000
Carrying Value of Bonds = Face Value + Unamortized Bond Premium
= $200,000 + $8,200 = $208,200
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10–29
Bond Issue Costs
 Can amount to
as much as 5
percent of a
bond issue
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 Establish an account for these costs and
amortize over life of bonds
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10–30
Using Present Value to Value a Bond
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10–31
Influence of the Market Interest Rate
on Bonds
The market interest rate varies from day to day
and therefore what investors are willing to pay
changes as well
 If current market interest rate > bond’s
interest rate, investors are willing to pay less
 If current market interest rate < bond’s
interest rate, investors are willing to pay more
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10–32
Case 1: Present Value
Market interest rate > Face interest rate
A bond has a face value of $20,000 and pays fixed interest of $900
every six months (a 9 percent annual rate). The bond is due in 5 years
and the market interest rate is 12 percent.
What is the present value of the bond?
Determine the interest rate and number of periods to use in the present value tables
• Divide the annual interest rate by the number of periods in the year
12% ÷ 2 = 6%
• Multiply the number of periods in one year by the number of years
2 x 5 = 10 periods
Present value of 10 periodic payments @ 6%
Present value of a single payment at the end
of 10 periods @ 6%
Present value of $20,000 bond
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Table 2
$900 x 7.360
$6,624.00
Table 1
$20,000 x .558
11,160.00
$17,784.00
10–33
Case 2: Present Value
(hwk E 7)
Market interest rate < Face interest rate
A bond has a face value of $20,000 and pays fixed interest of $900
every six months (a 9 percent annual rate). The bond is due in 5 years
and the market interest rate is 8 percent.
What is the present value of the bond?
Present value of 10 periodic payments @ 4%
Table 2
$900 x 8.111
$7,299.90
Present value of a single payment at the end
of 10 periods @ 4%
Table 1
$20,000 x .676
13,520.00
Present value of $20,000 bond
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$20,819.90
10–34
Amortization of Bond Discounts
and Premiums
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10–35
Bond Discounts or Premiums
Amount by which the total interest
cost is higher or lower than the
total interest payments
Amortized over the
life of the bonds
Use straight-line or
effective interest
method
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10–36
Total Interest Cost Illustrated
Bharath Corporation issues $200,000 of 9 percent, 5-year
bonds at 96.149 when the market rate is 10 percent. The
bonds sold for $192,298 resulting in an unamortized bond
discount of $7,702.
The bonds were issued at a discount:
 The interest rate paid by the company is greater than the face interest
rate on the bonds
 Although the company does not receive the full face value of the
bonds on issue, it still must pay back the full face value at maturity
Interest Cost to Company  Stated Interest Payments  Amount of Bond Discount
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10–37
Calculating Total Interest Cost
Bharath Corporation issues $200,000 of 9 %, 5-year bonds at
96.149 when the market rate is 10 percent. The bonds sold for
$192,298, resulting in an unamortized bond discount of $7,702.
Cash to be paid to bondholders
Face value at maturity
Interest payments ($200,000 x .09 x 5 years)
Total cash paid to bondholders
Less cash received from bondholders
Total interest cost
$200,000
90,000
$290,000
192,298
$ 97,702
Or, alternately
Interest payments ($200,000 x .09 x 5 years)
Bond discount
Total interest cost
$90,000
7,702
$97,702
The bond discount increases the interest paid on the bonds from
the stated interest rate to the effective interest rate.
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10–38
Accounting for Total Interest Cost
Effective Interest Rate = Stated Rate + Discount
Amortization of the bond discount
 Must be allocated over the remaining life of the bonds as
an increase in the interest expense each period
 Interest expense for each period will exceed the actual
payment of interest by the amount of the bond discount
amortized over the period
Zero coupon bonds are issued by some companies and
governmental units
 Do not require periodic interest payments
 Represent a promise to pay a fixed amount at the maturity
date
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10–39
Effective Interest Method
Applies a constant interest rate to the carrying value of
bonds at the beginning of the interest period
 Rate equals the market,
or effective, rate at the
time the bonds were
issued.
 Amount amortized is the
difference between
interest computed and
actual interest paid to
bondholders
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10–40
Interest and Amortization of a Bond
Discount: Effective Interest Method
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10–41
Bond Amortization –
Effective Interest Method
Face value = $200,000
Face Interest rate = 9%
Life of bond = 5 years
Column A
Carrying value =
Face value –
Unamortized bond
discount
A
Semiannual
Interest
Period
0
1
Carrying
Value at
Beginning of
Period
$192,298
Interest payments = Semiannual
Bond discount = $7,702
Column B – Use market interest rate
($192,298 x .10 x 6/12 = $9,615)
Column C – Use face interest rate on bond
($200,00 x .09 x 6/12 = $9,000)
B
Semiannual
Interest
Expense at
10% to be
Recorded
(5% x A)
C
Semiannual
Interest to be
Paid to
Bondholders
(4.5% x
$100,000)
$9,615
$9,000
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D
E
F
Amortization
of Bond
Discount
(B – C)
Unamortized
Bond
Discount at
End of Period
(E – D)
$7,702
Carrying
Value at End
of Period
(A + D)
$192,298
10–42
Bond Amortization –
Effective Interest Method (cont’d)
Column D
Discount amortized =
Effective interest expense –
Actual interest payment to
bondholders
($9,615 – $9,000 = $615)
A
Semiannual
Interest
Period
0
1
Carrying
Value at
Beginning of
Period
$192,298
Column F
Carrying value at beg. of
period + Amort. during the
period
($192,298 + $615 =
$192,913)
B
Semiannual
Interest
Expense at
10% to be
Recorded
(5% x A)
C
Semiannual
Interest to be
Paid to
Bondholders
(4.5% x
$100,000)
$9,646
$9,000
Notice that the sum of the
carrying value and the
unamortized discount always
equals the face value of the bonds
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D
Amortization
of Bond
Discount
(B – C)
$615
E
F
Unamortized
Bond
Discount at
End of Period
(E – D)
$7,702
7,087
Carrying
Value at End
of Period
(A + D)
$192,298
192,913
Column E
Bond discount at beg. of period –
Current pd amort. ($7,702 – $615 = $7,087)
10–43
Bond Amortization –
Effective Interest Method (cont’d)
Record first semiannual interest payment and
amortization of bond discount:
2010
July 1
Bond Interest Expense
9,615
Unamortized Bond Discount
Cash (or Interest Payable)
Paid (or accrued) semiannual interest
to bondholders and amortized
discount on 9%, 5-year bonds
615
9,000
It is not necessary to prepare an interest
and amortization table to determine
amortization of a discount for the period
Amount of Interest t o Amortize  (Carrying Value  Effective Interest Rate) – Interest Payment
 ($192,298  .05) – $9,000  $615
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10–44
Carrying Value and Interest Expense –
Bonds Issued at a Discount
(hwk E 12)
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10–45
Bond Premiums
 Bondholders pay
more than face value
for bonds
 Premium is an amount
that bondholders will
receive over the life
of the bond issue (it
is a reduction, in
advance, of the total
interest paid on the
bonds over life of the
issue)
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10–46
Total Interest Cost
Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at 104.1
on January 1, 2010, when the market rate is 8 percent. The bonds sold for
$208,200 resulting in an unamortized bond premium of $8,200.
Cash to be paid to bondholders
Face value at maturity
Interest payments ($200,000 x .09 x 5 years)
Total cash paid to bondholders
Less cash received from bondholders
Total interest cost
$200,000
90,000
$290,000
208,200
$ 81,800
Or, alternately
Interest payments ($200,000 x .09 x 5 years)
Less bond premium
Total interest cost
$90,000
8,200
$ 81,800
The bond premium decreases the interest paid on the bonds from the
stated interest rate to the effective interest rate.
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10–47
Interest and Amortization of a Bond
Premium: Effective Interest Method
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10–48
Bond Amortization – Effective Interest
Method (cont’d)
Record first semiannual interest payment and amortization of bond
premium:
2010
July 1
Bond Interest Expense
8,328
Unamortized Bond Premium
672
Cash (or Interest Payable)
Paid (or accrued) semiannual interest
to bondholders and amortized
premium on 9%, 5-year bonds
9,000
It is not necessary to prepare an interest
and amortization table to determine
amortization of a premium for the period
Amount of Interest t o Amortize  Interest Payment - (Carrying Value  Effective Interest Rate)
 $9,000 – ($208,200  .04)  $672
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10–49
Carrying Value and Interest Expense –
Bonds Issued at a Premium
(hwk E 11)
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10–50
Retirement of Bonds
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10–51
Calling Bonds
Why call bonds before their maturity date?
 If bond interest rates drop, the company can call
the bonds and reissue debt at a lower interest
rate.
 Company has earned enough to pay off the debt.
 The reason for having the debt no longer exists.
 The company wants to restructure its debt to
equity ratio.
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10–52
Callable Bonds Illustrated
The issuer has the right to buy back and retire bonds at a
specified call price
Bharath Corporation can call or retire at 105 the $200,000 of bonds it
issued at a premium (104.1). It decides to do so on July 1, 2013. The
entry for the required interest payment and amortization of the
premium has already been made.
Record the retirement of the bonds:
2013
July 1
Bonds Payable
Unamortized Bond Premium
Loss on Retirement of Bonds
Cash
Retired 9% bonds at 105
200,000
2,892
7,108
210,000
The loss occurs because the call price of the bonds is greater than the carrying value
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10–53
Callable Bonds (Purchase)
(hwk E13)
Bharath Corporation can call or retire at 105 the $200,000 of bonds it
issued at a premium (104.1). Because of a rise in interest rates, Bharath is
able to purchase the $200,000 bond issue on the open market for 85. The
entry for the required interest payment and amortization of the premium
has already been made.
Record the purchase of the bonds:
2013
July 1
Bonds Payable
Unamortized Bond Premium
Cash
Gain on Retirement of Bonds
Purchased and retired 9%
bonds at 85
200,000
2,892
170,000
32,892
The gain occurs because the call price of the bonds is less than than the carrying
value
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10–54
Convertible Bonds Illustrated
(hwk E14)
Bharath Corporation issued $200,000 of convertible bonds on January
1, 2010, that can be converted to 40 shares of common stock for each
$1,000 bond. The bondholders decide to convert all the bonds to $8 par
value common stock on July 1, 2013.
Record the bond conversion:
2013
July 1
Bonds Payable
200,000
Unamortized Bond Premium
2,892
Common Stock
Additional Paid-in Capital
Converted 9% bonds payable into $8
par value common stock at a rate of
40 shares for each $1,000 bond
64,000
138,892
No loss or gain is recorded because the bond
liability and the associated unamortized discount
or premium are written off the books.
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