Financial & Managerial
Accounting 2002e
Belverd E. Needles, Jr.
Marian Powers
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Santa Fe Community College
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1
Chapter 11
Long-Term Liabilities
LEARNING OBJECTIVES
1. Identify the management issues related to
issuing long-term debt.
2. Identify and contrast the major characteristics
of bonds.
3. Record the issuance of bonds at face value and
at a discount or premium.
4. Use present values to determine the value of
bonds.
5. Use the straight-line and effective interest
methods to amortize bond discounts and
premiums.
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3
LEARNING OBJECTIVES
(continued)
6. Account for bonds issued between interest
dates and make year-end adjustments.
7. Account for the retirement of bonds and
the conversion of bonds into stock.
8. Explain the basic features of mortgages
payable, installment notes payable, longterm leases, and pensions and other
postretirement benefits as long-term
liabilities.
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4
Management Issues Related to
Issuing Long-Term Debt
OBJECTIVE 1
Identify the management issues
related to issuing long-term
debt.
Long-Term Liabilities
 Obligations
of business that are due to be paid after
one year or beyond the operating cycle, whichever is
longer.
 Decisions related to long-term debt are critical
because how a company finances its operations is
the most important factor in the company’s longterm viability.
 The amount and type of debt a company incurs
depends on many factors, including the nature of
the business, its competitive environment, the state
of the financial markets, and the predictability of its
earnings.
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6
Reasons and Resources for
Long-Term Debt


Growing businesses frequently need long-term
financing to invest in R&D activities and longterm assets.
Two key sources of long-term funds:
1. Issuance of capital stock.
2. Issuance of long-term debt such as bonds, notes,
mortgages, and leases.

Related management issues:
1. Whether or not to have long-term debt.
2. How much long-term debt to have.
3. What types of long-term debt to have.
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7
The Decision to Issue
Long-Term Debt
 A key
management decision is whether to rely
solely on stockholders’ equity or to rely partially on
long-term debt for long-term funds.
 Advantages of common stock over debt.
It does not have to be paid back.
 Dividends are paid only if the company earns sufficient
income.

 Advantages
of long-term debt over common stock.
Stockholder control – creditors do not elect directors.
 Tax effects - interest is tax deductible.
 Financial leverage – after interest is paid, all excess
earnings accrue to stockholders.

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8
Average Debt to Equity for Selected Industries
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9
Disadvantages of Debt Financing
Cash
is required to make periodic
interest payments and to pay back
the principal amount.
Company can become overcommited.
Financial leverage can work against a
company if the earnings from its
investments do not exceed its interest
payments.
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10
How Much Debt
 The
use of debt financing varies widely across
industries.
 Failure to make timely payments could force a
company into bankruptcy.
 The interest coverage ratio (ICR) is a measure of how
much risk a company is undertaking with its debt.
 The ICR measures the degree of protection a
company has from default on interest payments.
ICR = Income Before Taxes + Interest Expense
Interest Expense
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11
What Types of Long-Term Debt
 Long-term
bonds (debentures) have different
characteristics.
Time until repayment.
 Amount of interest.
 Ability to repay early.
 Conversion into other securities.

 Other
types of long-term debt.
Long-term notes.
 Mortgages.
 Long-term leases.

 Long-term
financing must be structured to the
best advantage of the company.
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12
Discussion
Q. What are the advantages and disadvantages of
issuing long-term debt?
A. Advantages of long-term debt are (1) common
stockholders do not relinquish control, (2)
interest on debt is tax deductible, and (3)
financial leverage may increase a company’s
earnings. Disadvantages of long-term debt are
(1) interest and principal must be repaid on
schedule, and (2) financial leverage can work
against a company if a project is not successful.
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13
The Nature of Bonds
OBJECTIVE 2
Identify and contrast the major
characteristics of bonds.
The Nature of Bonds
A
bond is a security, usually long term,
representing money borrowed from the
investing public by a corporation or some
other entity.
 Bonds must be repaid at a specified time and
require periodic (usually semiannual)
payments of interest.
 Bondholders are creditors.
 Bonds are promises to repay the amount
borrowed (principal) and interest at a
specified rate on specified future dates.
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15
The Nature of Bonds
(continued)
 The
bondholder receives a bond certificate or
registration number as evidence of the
organization's debt.
 A bond issue is the total number of bonds
issued at one time.
 A bond indenture defines the rights,
privileges, and limitations of the
bondholders.
 The bond indenture describes the maturity
date, interest payment dates, interest rate,
and other characteristics of the bonds.
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16
The Nature of Bonds (continued)
The
price of bonds is stated in terms of
a percentage of face (or par) value.
A quote of 103 1/2 means the price is
$1,035 per $1,000 bond.
When a bond is sold above 100, it sells
at a premium.
When a bond is sold below 100, it sells
at a discount.
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17
Bond Features
A bond
indenture is written to fit the
financing needs of a business.
Bonds may have several features.
 Secured
or unsecured.
 Term or serial.
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18
Secured or Unsecured Bonds
Unsecured
(debentures) are issued
based on the company’s credit rating.
Secured bonds give bondholders a
pledge of certain assets as a
guarantee of repayment.
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19
Term or Serial Bonds
Term
bonds all mature at the
same time.
Serial bonds mature on several
different dates.
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20
Discussion
Q. What are a bond certificate, a bond issue,
and a bond indenture?
A. A bond certificate is the document that gives
evidence of a company’s debt to a
bondholder. A bond issue is the total amount
of bonds made available at one time. A bond
indenture is the supplementary agreement
that specifies the characteristics of the bond
issue.
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21
Accounting for Bonds Payable
OBJECTIVE 3
Record the issuance of
bonds at face value and at a
discount or premium.
Accounting for Bonds Payable
 When
the board of directors decides to
issue bonds, it presents the proposal to the
stockholders for approval.
 Certificates and bond agreement are
prepared.
 When bonds are authorized, no journal
entry is required.
 Normally, a memorandum is prepared
giving the particulars of the bond issue.
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23
Balance Sheet
Disclosure of Bonds

Bonds are disclosed on the balance
sheet in one of two ways:
1. Usually as long-term liabilities.
2. Possibly as current liabilities if
maturity date is within one year.
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24
Important Provisions of the
Bond Indenture
 Important
provisions of the bond indenture
are reported in the notes to the financial
statements.
 List
of bond issues.
 Kinds of bonds.
 Interest rates.
 Any securities connected with the bonds.
 Interest payment dates.
 Maturity dates.
 Effective interest rates.
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25
Bonds Issued at Face Value
Jan. 1 Cash
100,000
Bonds Payable
100,000
Sold $100,000 of 9%,
5-year bonds at
face value,
interest paid Jan. 1 and July 1
July 1 Bond Interest Expense
4,500
Cash
4,500
Semiannual interest
$100,000 x .09 x 6/12 year
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26
Face and Market Interest Rate
Interest Rate – the rate of interest, on an
annual basis, paid to bondholders, expressed as a
percentage of the face value of the bond.
 Market Interest Rate – the rate of interest paid in
the market on bonds of similar risk, also called
effective interest rate.
 Discounts or Premiums result from a difference
between the Market Interest Rate on date of issue
and the Face Interest Rate, established by the bond
issuer prior to the date of issue.
 Face
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27
Bonds Issued at a Discount
Jan. 1 Cash
Unamortized Bond Discount
Bonds Payable
Sold $100,000 of
9%, 5-year bonds at 96.149
Face amount of bonds
Less purchase price
Unamortized bond discount
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96,149
3,851
100,000
$100,000
96,149
$ 3,851
28
Bonds Issued at a Premium
Jan. 1 Cash
Unamortized Bond
Premium
Bonds Payable
104,100
4,100
100,000
Sold $100,000 of
9%, 5-year bonds at 104.1
Purchase price
$104,100
Less face amount
100,000
Unamortized premium $ 4,100
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29
Bond Issue Costs
 Fees
to underwriters.
 Amortized
over the life of the bonds in a
separate account.
 Bond
issue costs decrease the amount of cash
received.
 Increase
bond discount.
 Decrease bond premium.
 Bond
issue costs can be spread over the life
of the bonds through the amortization of a
discount or premium.
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30
Discussion
Q. Under what circumstance does a
bond sell at face value?
A. When the face interest rate of the
bond is identical to the market
interest for similar bonds on the
date of issue.
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31
Using Present Value to
Value a Bond
OBJECTIVE 4
Use present values to
determine the value of
bonds.
Using Present Value to
Value a Bond

Present value is relevant to the study of
bonds because the value of a bond is based
on the present value of two components of
cash flow:
1. A series of fixed interest payments.
2. A single payment at maturity.

The amount of interest a bond pays is fixed
over its life.
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33
Influence of the
Market Interest Rate
 The
market interest rate varies from day to
day and therefore what investors are willing to
pay changes as well.
 If the current market interest rate is now
greater than the bond’s interest rate, investors
are willing to pay less.
 If the current market interest rate is now less
than the bond’s interest rate, investors are
willing to pay more.
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34
Discussion
Q. A corporation sold $500,000 of 5%,
$1,000 bonds on the interest payment date.
What would the proceeds from the sale be
if the bonds were issued at 95, at 100, and
at 102?
A. The proceeds from the sale of $500,000 in
bonds at 95 would be $475,000; at 100,
$500,000; and at 102, $510,000.
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35
Present Value of a Bond
 For
a bond with a face value of $10,000, paying
$450 every 6 months (9% annual rate), due in 5
years, cash flows to bondholder are 9 payments of
$450 every six months, followed by one payment of
$10,450.
 If the Market Rate is 14% on date of issue, use
tables, calculator, or computer for number of
periods = 10, i = 7%, to give present value of cash
flows = $8,240.80.
 If the Market Rate is 8% on date of issue, number
of periods = 10, i = 4%, to give present value of
cash flows = $10,409.95.
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36
Amortizing a Bond Discount
OBJECTIVE 5
Use the straight-line and
effective interest methods to
amortize bond discounts and
premiums.
Bond Discount Issues






When a bond is sold at a discount, the discount affects
interest expense in each year of the bond issue.
Discount should be amortized over the life of the issue.
Unamortized bond discount decreases gradually over time.
Carrying value = Face value – discount.
Carrying value increases gradually.
By maturity date:
 The carrying value of the issue equals the face value
amount of the bonds.
 The unamortized bond discount is zero.
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38
Calculation of Total Interest Cost
 When
bonds are sold at a discount, the effective
interest rate paid by the company is greater than
the face interest rate on the bonds.


Total Interest Cost = Total Stated Interest + Bond Discount.
Actual Interest Expense =
(Issue Price - Face Value) + Total Interest Payments.
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39
Calculation of Total Interest Cost
(continued…)
Cash to be paid to bondholders
Face value at maturity
Interest payments
Total cash to be paid
Less cash received
Total interest cost
$100,000
45,000
$145,000
96,149
$ 48,851
Or
Interest Payments
Bond discount
Total interest cost
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$45,000
3,851
$48,851
40
Accounting for Total Interest Cost
 Effective
Interest Rate = Stated Rate + Discount.
 The discount must be allocated over the remaining
life of the bonds as an increase in the interest
expense each period; this is amortization of the
bond discount.
 The 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.
They do not require periodic interest payments.
 They represent a promise to pay a fixed amount at the
maturity date.

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41
Methods of Amortizing
a Bond Discount
Straight-line
method: only used
when not significantly different
from effective interest method.
Effective interest method:
preferred by APB.
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42
Carrying Value and Interest Expense - Bonds Issued at a Discount
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43
Methods of Amortizing a Bond Discount
Straight-Line Method:
Equal amortization of bond discount over each accounting period.
Bond Discount = $3,851
Number of interest periods = 10
Amortization of Bond Discount per Interest Period = $385
First, semiannual interest payment:
July 1
Bond Interest Expense
Unamortized Bond Discount
Cash
4,885
385
4,500
Paid semiannual interest to bondholders and amortized the discount
on 9%, 5-year bonds.
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44
Methods of Amortizing a Bond Discount
Effective Interest Method:
Apply a constant rate of interest to the carrying value at the beginning of
each accounting period.
Face value of bond
$10,000
Bond discount
3,851
Carrying value at beginning of
first period:
$96,149
Semiannual interest expense @ 5%
$4,807
Cash paid to bondholder
4,500
Amortization of bond discount for first
interest period:
$307
Bond discount (at end of first period) $3,544
Carrying value at end of first period
$96,456
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($3,851 - $307)
($10,000 - $3,544)
45
Amortizing a Bond Premium
A bond
premium represents an
amount that bondholders will not
receive at maturity.
The premium is a reduction, in
advance, of the total interest paid on
the bonds over the life of the bond
issue.
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46
Calculation of Total Interest Cost
Cash to be paid to bondholders
Face value at maturity
Interest payments ($100,000 x .09 x 5yrs)
Total cash to be paid
Less cash received
Total interest cost
$100,000
45,000
$145,000
104,100
$ 40,900
Total interest payments of $45,000 exceed the
total interest costs of $40,900 by $4,100, the
amount of the bond premium.
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47
Straight-Line Method of
Amortizing a Bond Premium


Bond premium is spread evenly over the life of the bond issue.
 Bond Interest = Stated Interest - Premium.
Bond Interest Expense per period = Total Interest Cost ÷
Number of periods
July 1 Bond Interest Expense
Unamortized Bond Premium
Cash
4,090
410
4,500
Paid semiannual interest and
amortized premium on
9%, 5-year bonds
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48
Effective Interest Method of
Amortizing a Bond Premium



The interest expense decreases slightly each period
because the amount of the bond premium amortized
increases slightly each period.
Apply a constant interest rate to the carrying value at the
beginning of each period.
July 1 Bond Interest Expense
Unamortized Bond Premium
Cash
Paid semiannual
interest to bondholders and
amortized premium on 9%,
5-year bonds
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4,164
336
4,500
49
Carrying Value and Interest Expense - Bonds Issued at a Premium
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50
Discussion
Q. Why is a bond discount considered a
component of total interest cost?
A. A bond discount represents the
amount in excess of the issue price
that must be paid by the corporation
at the time of maturity.
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51
Other Bonds Payable Issues
OBJECTIVE 6
Account for bonds issued
between interest dates and
make year-end adjustments.
Sale of Bonds Between Interest Dates



Generally accepted method is to collect from
investors the interest that would have accrued for
the partial period preceding the issue date.
When the first interest period is completed, the
corporation pays investors the interest for the
entire period.
This procedure is followed for two reasons:
1. Decreases bookkeeping for sales at various dates.
2. When the accrued amount is netted against the full
interest paid on the interest payment date, the result is
the interest expense for the time the money was
borrowed.
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53
Accounting for Sale of Bonds Between
Interest Dates
May 1 Cash
103,000
Bond Interest Expense
Bonds Payable
Sold 9%, 5-year bonds
at face plus 4 months’
accrued interest
$100,000 x .09 x 4/12 = $3,000
July 1
Bond Interest Expense
4,500
Cash
Paid semiannual interest
$100,000 x .09 x 6/12 = $4,500
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3,000
100,000
4,500
54
Effect on Bond Interest Expense
When Bonds Are Issued Between Interest Dates
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55
Year-End Accrual for Bond Interest
Expense
 Assume
Sept. 30
fiscal year ends Sept. 30
Bond Interest Expense
Unamortized Bond
Premium
Interest Payable
2,075.50
174.50
2,250.00
To record accrual of interest on
9% bonds payable for 3 months
and amortization of one half of the
premium for the second interest
payment period
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56
 When
the next interest payment date occurs:
Jan. 1 Bond Interest Expense
2,075.50
Interest Payable
2,250.00
Unamortized Bond
Premium
174.50
Cash
4,500.00
Paid semiannual interest
including interest previously
accrued, and amortized the
premium for the period since
the end of the fiscal year
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57
Discussion
Q. When bonds are issued between interest dates, why is
it necessary for the issuer to collect an amount equal
to accrued interest from the buyer?
A. Because the full period’s interest is paid on interest
dates to the holders on those dates, the interest must
be allocated between the buyer and the seller when a
sale takes place between interest dates. The buyer
pays the seller the accrued interest for the period
since the last interest date.
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58
Retirement of Bonds
OBJECTIVE 7
Account for the retirement of
bonds and the conversion of
bonds into stock.
Retirement of Bonds
Most
bond issues give the corporation a
chance to buy back and retire the
bonds at a call price, usually above face
value, before maturity.
Such bonds are known as callable
bonds.
The retirement of a bond issue before
its maturity date is called early
extinguishment of debt.
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60
Accounting for
Retirement of Bonds
 Retirement
of Bonds (on an interest payment date) at
105, as stated in the bond indenture.
July 1 Bonds Payable
100,000
Unamortized Bond Premium
1,447
Loss on Retirement of Bonds
3,553
Cash
105,000
Retired 9% bonds at 105
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61
Conversion of Bonds into
Common Stock
 Convertible
bonds can be exchanged for other
securities of the corporation.
 Convertibility enables an investor to make
more money because if the market price of
the common stock rises, the value of the
bonds rises.
 If the stock price does not rise, the investor
still holds the bonds and receives both
interest payments and principal at the
maturity date.
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62
Reasons a Company Issues Convertible Bonds
1. Desirability of convertible bonds to investors enable
companies to issue at lower interest rates – lower cost.
2. Management does not give up any control – bondholders
have no voting rights.
3. Bond interest expense is tax deductible – tax savings.
4. If the company earns a return higher than the interest
expense, income will increase.
5. Financial flexibility: If stock price increases and convertible
bond price exceeds face value, management can avoid
repaying bonds because bondholders will want to convert
into common stock.
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63
Possible Disadvantages of
Convertible Bonds
1. Bond interest payments must be made on
stated dates (usually semiannually.) Failure
to do so can lead to bankruptcy.
2. When bonds are converted, bondholders
become stockholders with additional rights,
e.g. voting rights.
3. Conversion to common stock dilutes
existing stockholders’ ownership.
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64
Accounting for Conversion of
Bonds into Common Stock
July 1 Bonds Payable
100,000
Unamortized Bond Premium
1,447
Common Stock
32,000
Paid-in Capital in Excess
of Par Value, Common
69,447
Converted 9% bonds payable
into $8 par value common stock
at a rate of 40 shares for each
$1,000 bond
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65
Discussion
Q. Why would a company want to exercise the
callable provision of a bond when it can wait to
pay off the debt?
A. A company may have earned enough money to
pay off the debt; the reason for the debt may
no longer exist; market conditions may have
changed, making it cost-effective to call the
debt; or the company may want to restructure
its debt to equity ratio.
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66
Other Long-Term Liabilities
OBJECTIVE 8
Explain the basic features of mortgages
payable, installment notes payable,
long-term leases, and pensions and
other postretirement benefits as longterm liabilities.
Mortgages Payable
 A mortgage
is a long-term debt secured by real
property, usually paid in equal monthly
installments.
July 1 Mortgage Payable
Mortgage Interest Expense
Cash
Made monthly mortgage
payment
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300
500
800
68
Installment Notes Payable



Installment notes payable occur when the terms of a note call
for a series of periodic payments.
Each payment includes the interest to date plus a repayment
of part of the amount that was borrowed.
On 12/31/x1, $100,000 is borrowed on a 15%, 5-year
installment note.
12/31/x1
Cash
Notes Payable
100,000
100,000
Borrowed $100,000
at 15% on a 5-year
installment note
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69
Payments of Accrued Interest Plus
Equal Amounts of Principal
12/31/x2 Notes Payable
Interest Expense
Cash
Made first installment
payment on note
$100,000 x .15 = $15,000
20,000
15,000
12/31/x3
20,000
12,000
Notes Payable
Interest Expense
Cash
Made second installment
payment on note
$80,000 x .15 = $12,000
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35,000
32,000
70
Payments of Accrued Interest Plus
Increasing Amounts of Principal
12/31/x2 Notes Payable
Interest Expense
Cash
Made first installment
payment on note
14,833
15,000
12/31/x3 Notes Payable
Interest Expense
Cash
Made second installment
payment on note
17,058
12,775
29,833
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29,833
71
Long-Term Leases

There are several ways for a company to obtain new
operating assets.
1. Borrow money and buy the asset.
 Asset and liability are recorded at the amount paid.
 Asset is subject to periodic depreciation.
2. Rent the asset on a short-term lease.
 Operating lease.
 Risks of ownership remain with the lessor.
3. Obtain the asset on a long-term lease.
 Requires no immediate cash payment.
 Cost is less than a short-term lease.
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72
Related Accounting Issues for
Long-Term Leases




Often the lease cannot be canceled.
Duration of the lease may be about the same as
the useful life of the asset.
There may be a provision for the lessee to buy
the asset at the end of the lease term.
Similar to an installment purchase.
If a lease meets the above conditions, the FASB
rules that it should be accounted for as a
Capital Lease.
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73
Capital Leases
 A capital
lease is more like a purchase or installment
sale.
 The lessee must record an asset and a long-term
liability equal to the present value of the lease
payments over the lease term.
 Each lease payment consists of interest and
repayment of debt.
 Depreciation is computed on the asset.
 A lease is recorded as follows:
Equipment Under Capital Lease
14,740
Obligations Under Capital Lease
14,740
Record capital lease on machinery
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74
Capital Leases
(continued…)
Equipment
Under Capital Lease is
classified as a long-term asset.
Obligations Under Capital Lease is
classified as a long-term liability.
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75
Accounting for Long-Term Leases
 Record
depreciation as follows:
Depreciation Expense,
Equipment Under Capital Lease
Accumulated Depreciation,
Equipment Under Capital Lease
To record depreciation expense
on capital lease
a payment as follows:
Interest Expense
Obligations Under Capital Lease
Cash
2,457
2,457
 Record
2,358
1,642
4,000
Made payment on capital lease
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76
Pensions
 A pension
plan is a contract between a company and
its employees in which the company agrees to pay
benefits to the employees after they retire.
 Contributions from the employee and the company
are paid into a pension fund.
 Defined contribution plans require that the employer
contribute an annual amount specified by an
agreement between the company and its employees
or a resolution of the board of directors.
 Pensions are accounted for by a debit to Pension
Expense and a credit to Cash or a liability.
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77
Pensions (continued)
Defined benefit plans require that the employer’s
annual contribution is the amount needed to fund
pension liabilities arising from employment in the
current year, but the exact amount will not be
determined until the retirement and death of the
current employees.
 Accounting is complex, as discussed in FASB # 87.
 The amount of pension expense must first be
determined.
 If the amount of cash contributed to the fund is less
than the pension obligation, a balance sheet liability
exists.

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78
Other Postretirement Benefits
Postretirement
benefits are in addition
to pension benefits and include health
care and other benefits.
In the past, they were accounted for on
a cash basis.
The FASB has concluded that they
should be estimated and accrued while
the employee is working, in order to
follow the matching principle.
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79
Discussion
Q. What is a pension plan? What assumptions must
be made to account for the expenses of such a
plan?
A. A pension plan is a contract between a company
and its employees in which the company agrees to
pay benefits to the employees after they retire.
Among the assumptions that must be made to
determine the costs of a pension plan are the
average remaining service life of active
employees, the expected return on pension plan
assets, and expected future salary increases.
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80
OK, LET’S REVIEW . . .
1. Identify the management issues related to
issuing long-term debt.
2. Identify and contrast the major
characteristics of bonds.
3. Record the issuance of bonds at face value
and at a discount or premium.
4. Use present values to determine the value
of bonds.
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81
CONTINUING OUR REVIEW . . .
5. Use the straight-line and effective interest
methods to amortize bond discounts and
bond premiums.
6. Account for bonds issued between interest
dates and make year-end adjustments.
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82
AND FINALLY . . .
7. Account for the retirement of bonds and
the conversion of bonds into stock.
8. Explain the basic features of mortgages
payable, installment notes payable, longterm leases, and pensions and other
postretirement benefits as long-term
liabilities.
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83