Accounting Principles, 7th Edition Weygandt • Kieso • Kimmel Chapter 16 LONG-TERM LIABILITIES Prepared by Naomi Karolinski Monroe Community College and Marianne Bradford Bryant College John Wiley & Sons, Inc © 2005 CHAPTER 16 LONG-TERM LIABILITIES After studying this chapter, you should be able to: Explain why bonds are issued Prepare the entries for the issuance of bonds and interest expense Describe the entries when bonds are redeemed or converted Describe the accounting for long-term notes payable Contrast the accounting for operating and capital leases Identify the methods for the presentation and analysis of long-term liabilities Long-Ter m Liabilities • Obligations that are expected to be paid after one year • Include bonds, long-term notes, and lease obligations Bond Basics STUDY OBJECTIVE • Bonds – interest-bearing notes payable – issued by corporations, universities, and governmental agencies – like common stock, can be sold in small denominations (usually a thousand dollars) – attract many investors • To obtain large amounts of long-term capital, corporate management usually must decide whether to issue bonds or to use equity financing (common stock) Why Issue Bonds? Long-term financing, bonds, offer the following advantages over common stock: 1)Stockholder control not affected 2)Tax savings 3)Earnings per share may be higher Disadvantages of Bonds 1)Interest must be paid on a periodic basis 2)Principal (face value) must be repaid at maturity Types of Bonds Secured and Unsecured 1) Secured bonds Specific assets of the issuer pledged as collateral for the bonds( a mortgage bond is secured by real estate) 2) Unsecured bonds Issued against the general credit of the borrower; they are also called debenture bonds Types of Bonds: Ter m and Serial Bonds 3) Term bonds • bonds that mature at a single specified future date Registered 2005 2006 2007 2008 4) Serial bonds • bonds that mature in installments 2005 Registered 2006 2007 2008 Types of Bonds: Registered and Bearer 5)Registered bonds • issued in the name of the owner and have interest payments made by check to bondholders of record 6)Bearer or coupon bonds Registered Pay to: Joe Smith • not registered; thus bondholders must send in coupons to receive interest payments Registered Pay to: Types of Bonds Conver t ible and Callable • Convertible – convert the bonds into common stock at holder’s option • Callable – subject to call and retirement at a stated dollar amount prior to maturity at the option of the issuer APPENDIX: 16 B E ffective-Interest Amor t ization • An alternative to straight-line amortization • Both methods result in the same total amount of interest expense over the term of the bonds • If materially different – the effective-interest method is required under GAAP Computation of Amor t ization -EffectiveInterest Method • Bond interest expense – computed by multiplying the carrying value of the bonds at the beginning of the interest period by the effective-interest rate • Bond discount or premium amortization – computed by determining the difference between the bond interest expense and the bond interest paid (1) Bond Interest Expense Carrying value x Effective of Bonds at Beginning Interest of Period Rate (2) Bond Interest Paid Face Contractual Amount x Interest of Bonds Rate Amortization Amount Illustration 16B-3 Bond Discount Amor t ization Schedule Candlestick Inc issues $100,000 of 10%, 5-year bonds on January 1, 2005, with interest payable each July and January The bonds will sell for $92,639 with an effective interest rate of 12%; Therefore, the bond discount is $7,361 ($100,000 - $92,639) The schedule below facilitates recording of interest expense and discount amortization NOTE: TABLE WILL CONTINUE FOR 10 SEMIANNUAL PERIODS Issue date $7,361 $92,639 $5,000 $5,558 $ 558 6,803 93,197 $5,000 5,592 592 6,211 93,789 Illustration 16B-4 Bond Premium Amor t ization Schedule Candlestick Inc issues $100,000 of 10%, 5-year bonds on January 1, 2005, with interest payable each July and January The bonds will sell for $108,111 with an effective interest rate of 8%; therefore, the bond premium is $8,111 ($108,111-$100,000) The schedule below facilitates recording of interest expense and premium amortization NOTE: TABLE WILL CONTINUE FOR 10 SEMIANNUAL PERIODS Issue date $8,111 $108,111 $5,000 $4,324 $676 7,435 107,435 5,000 4,297 703 6,732 106,732 Appendix 16C Straight-Line Amortization • Matching principle – bond discount allocated systematically to each accounting period that benefits from the use of the cash proceeds • Straight-line method of amortization – allocates the same amount to interest expense each interest period • The amount is determined as follows: Bond Discount / Number of Interest Periods = Bond Discount Amortization Amor t izing Bond Discount In the previous example, the bond discount amortization is $736 ($7,361 /10 periods) The entry to record the payment of bond interest and the amortization of bond discount on the first interest date (July 1, 2005) is: 5,736 736 5,000 Amor t izing Bond Discount - Entries At December 31, the adjusting entry is: 5,736 736 5,000 Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity Thus, the carrying value of the bonds at maturity will be equal to the face value For m ula for Straight-Line Method of Bond Premium Amor t ization • The formula for determining bond premium amortization under the straight-line method is: Bond Premium / Number of Interest Periods = Bond Premium Amortization Amor t izing Bond Premium The premium amortization for each interest period is $811 ($8,111 / 10) The entry to record the first payment of interest on July is: 4,189 811 5,000 Amor t izing Bond Premium At December 31, the adjusting entry is: 4,189 811 5,000 Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity date of the bonds Time Diagr am Depicting Cash Flows $100,000 Principal $9,000 $9,000 $9,000 $9,000 $9,000 Interest year period Assume that Kell Company on January 1, 2005, issues $100,000 of 9% bonds, due in years, with interest payable annually at year-end The purchaser of the bonds would receive two cash payments: 1) principal of $100,000 to be paid at maturity, and 2) five $9,000 interest payments ($100,000 x 9%) over the term of the bond Computing the Mar ket Price of Bonds The market value of a bond is equal to the present value of all the future cash payments promised by the bond The present values of these amounts are shown below: Market price of bonds $100,000 Issuing Bonds Between Interest Dates When bonds are issued between interest payment dates, the issuer requires the investor to pay the market price for the bonds plus accrued interest since the last interest date To illustrate, assume that Deer Corporation sells $1,000,000, 9% bonds at face value plus accrued interest on March Interest is payable semiannually on July and January The accrued interest is $15,000 ($1,000,000 x 9% x 2/12) The total proceeds on the sale of the bonds, therefore, are $1,015,000 The entry to record the sale is: 1,015,000 1,000,000 15,000 Issuing Bonds Between Interest Dates At the first interest date, it is necessary to (1) eliminate the bond interest payable balance and (2) recognize interest expense for the months (March - June 30) the bonds have been outstanding Interest expense is $30,000 ($1,000,000 x 9% x 4/12) The entry on July for the $45,000 interest payment is: 15,000 30,000 45,000 COPYRIGHT Copyright © 2005 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein .. .CHAPTER 16 LONG-TERM LIABILITIES After studying this chapter, you should be able to: Explain why bonds are issued Prepare... Describe the entries when bonds are redeemed or converted Describe the accounting for long-term notes payable Contrast the accounting for operating and capital leases Identify the methods for the... long-term liability section of the balance sheet because the maturity date is more than one year away Accounting for Bond Issues Issuing Bonds at Face Value Assuming that interest is payable semiannually