chapter 15-1 long term liabilities 1. 1.quiz 2. 2.accounting for bonds (tfcs) 3. 3.accounting for...

Chapter 15-1

Long term Liabilities

1. Quiz

2. Accounting for Bonds (TFCs)

3. Accounting for Bonds / TFCs with serial maturity

4. Lease Accounting

5. Presentation & Analysis for Long Term Liabilities

6. Discussion of Assignments

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 15-2

Quiz shall be from annual report of Searle

Refer annual report of Searle (refer year 2010)

………………………

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 15-3

Chapter 15

Accounting Principles, Ninth Edition

Long-Term Liabilities

Chapter 15-4

Bonds (‘Term Finance Certificates’ as local statute labels) are a form of long term interest-bearing debt.

Three advantages over common stock:

Bond BasicsBond BasicsBond BasicsBond Basics

SO 1 Explain why bonds are issued.SO 1 Explain why bonds are issued.

1. Stockholder control is not affected.

2. Tax savings result.

3. Earnings per share may be higher without any new investment by the owners.

Chapter 15-5



Assume Global Limited has 100,000 (par value $25) shares issued and outstanding with existing following income statement

Operating Income $ 500,000Interest Expense -Pre Tax Income 500,000Income Tax (30%) (150,000)Net After Tax Income 350,000EPS $ 3.5

Assume further that Global finds a business opportunity with same ROI (20%) requiring & 5.0 million investment and promising further $ 1.0 million operating income

Chapter 15-6

Effects on earnings per share—stocks vs. bonds.



Illustration 15-2

1. When this benefit will be reversed?2. One of the ill affect of interest

Chapter 15-7

The major disadvantages resulting from the use of bonds are:

a. that interest is not tax deductible and the principal must be repaid.

b. that the principal is tax deductible and interest must be paid.

c. that neither interest nor principal is tax deductible.

d. that interest must be paid and principal repaid.

QuestionQuestion



Chapter 15-8

Types of Bonds

Secured and Unsecured (debenture) bonds.

Term and Serial bonds.

Registered and Bearer (or coupon) bonds.

Convertible and Callable bonds.



Chapter 15-9

Important TermsFace Value, Maturity Value and Issue Price

Nominal / Contractual Interest Rate

Bond Term

Interest Payment Dates

Market Rate of Interest

Effective Rate of Interest

Market Price of Bonds

Call Price

Conversion Ratio



Chapter 15-10

Issuing Procedures

Represents a promise to pay: 1. sum of money at designated maturity date, plus2. periodic interest at a contractual (stated) rate on the maturity amount (face value) in case of term bonds.

Paper certificate, typically PKR5000 face value.

Interest payments usually made semiannually or quarterly.

Generally issued when the amount of capital needed is too large for one lender to supply.- Private placement- Public placement



Check these terms for bonds

Chapter 15-11



Issuer of Bonds

Issuer of Bonds

MaturityDate

MaturityDate

Illustration 15-3

Contractual Interest

Rate

Contractual Interest

Rate

Face or Par ValueFace or

Par Value

Chapter 15-12

Determining the Market Value of Bonds

Market value is a function of the three factors that determine present value:

1. the dollar amounts to be received against principal and interests

2. the length of time until the amounts are received, and

3. the market rate of interest.



The features of a bond (callable, convertible, and so on) affect the market rate of the bond.

Chapter 15-13

Determining the Market Value of Bonds

Market Value = PV (Maturity Value) at market interest rate for maturity period [FV(1+i) ]

+ PV (interest payments) at market interest

rate for maturity period [R{1-(1+i) }/i]



-n

-n

Chapter 15-14

6%

8%

10%

Premium

Face Value

Discount

Assume Contractual Rate of 8%Assume Contractual Rate of 8%

Accounting for Bond IssuesAccounting for Bond IssuesAccounting for Bond IssuesAccounting for Bond Issues

SO 2 Prepare the entries for the issuance of bonds and interest expense.

Bonds Sold AtMarket Interest

Chapter 15-15 SO 2 Prepare the entries for the issuance of bonds and interest

expense.

The rate of interest investors demand for loaning funds to a corporation is the:

a. contractual interest rate.

b. face value rate.

c. market interest rate.

d. stated interest rate.

QuestionQuestion



expense.

Karson Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

c. the contractual interest rate and the market interest rate are the same.

d. no relationship exists between the two rates.

QuestionQuestion


Chapter 15-17

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is:

Issuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face Value


Jan. 1 Cash 100,000

Bonds payable 100,000

Chapter 15-18

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest ispayable semiannually on January 1 and July 1. Prepare the entry to record the payment of interest on July 1, 2010, assume no previous accrual (assuming no period closure on any month before).



July 1 Bond interest expense 5,000

Cash 5,000

Chapter 15-19

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable semiannually on January 1 and July 1. Prepare the entry to record the accrual of interest on December 31, 2010, assume no previous accrual.



Dec. 31 Bond interest expense 5,000

Bond interest payable 5,000

Jan, 1 Bond interest payable 5,000

Cash / Bank 5,000

Chapter 15-20

Illustration: On January 1, 2010, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest ispayable semiannually on January 1 and July 1.

Calculate total cost of debt



Total amount received against bonds is $100000

Total amount repaid is $100000 + $5000 x 10 = $150000

Total cost of borrowing = $50000

Chapter 15-21

Issuing Bonds at a DiscountIssuing Bonds at a DiscountIssuing Bonds at a DiscountIssuing Bonds at a Discount


Illustration: On January 1, 2010, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $92,639 (92.639% of face value). Interest is payable on July 1 and January 1. The entry to record the issuance is:Jan. 1 Cash 92,639

Discount on bonds payable 7,361

Bond payable 100,000Nature of ‘Discount’ account: ?Mrs. Bonds Payable, remains with bonds payable in balance sheet all the time, but reduces its valueIt’s valuation account for the liability ‘bonds payable’

Chapter 15-22

Statement PresentationStatement Presentation



Illustration 15-6

Chapter 15-23



Illustration: On January 1, 2010, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $92,639 (92.639% of face value). Interest is payable on July 1 and January 1.

Total amount received against bonds is $92639

Total amount to repay is $100000 + $5000 x 10 = $150000

Total cost of borrowing = $57,361

Chapter 15-24



Total Cost of BorrowingTotal Cost of Borrowing

Illustration 15-7

Illustration 15-8


expense.

Discount on Bonds Payable:

a. has a credit balance.

b. is a contra account.

c. is added to bonds payable on the balance sheet.

d. increases over the term of the bonds.

QuestionQuestion



expense.

Illustration: On January 1, 2010, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $108,111 (108.111% of face value). Interest is payable on July 1 and January 1. The entry to record the issuance is:Jan. 1 Cash 108,111


Premium on bond payable 8,111

Issuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a Premium

Nature of ‘Premium’ account: ? Mrs. Bonds payable, this time enhancing the value of bonds in balance sheetIt’s valuation account for the liability ‘bonds payable’

Chapter 15-27

Statement PresentationStatement Presentation


Issuing bonds at an amount different from face value is quite common. By the time a company prints the bond certificates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same.


Illustration 15-9


expense.

Total Cost of BorrowingTotal Cost of Borrowing

Illustration 15-10

Illustration 15-11


Chapter 15-29

Full Accounting for bonds issued at Full Accounting for bonds issued at discountdiscount

Nina Gera issued 100, Rs.5000, 9%, two years Nina Gera issued 100, Rs.5000, 9%, two years bonds on 1bonds on 1stst January 2008 at 95. Interest is January 2008 at 95. Interest is payable semiannually on 1payable semiannually on 1stst July and 1 July and 1stst January each.January each.

The point to note regarding accounting for The point to note regarding accounting for periodic interest expense is that expense will periodic interest expense is that expense will be recorded forbe recorded for 1- periodic interest due or paid; and1- periodic interest due or paid; and2- amortization of bonds discount 2- amortization of bonds discount Note: discount has debit balance and by the time bonds Note: discount has debit balance and by the time bonds will mature, it should have been wiped offwill mature, it should have been wiped off

Received Rs.475,000

Repaid Rs.500,000 so

Rs.25,000 discount is also part of the overall cost of debt

Chapter 15-30



Make the entries forMake the entries for- recording bonds issue on 1- recording bonds issue on 1stst Jan 2008 Jan 2008- interest payment on 1- interest payment on 1stst July 2008 and entry for discount July 2008 and entry for discount amortization (wipe off)amortization (wipe off)- interest adjusting entry on 31- interest adjusting entry on 31stst December 2008 and December 2008 and discount amortizationdiscount amortization- interest payment on 1- interest payment on 1stst January 2009 January 2009

Chapter 15-31



Repeat remaining entries for the next year (1Repeat remaining entries for the next year (1stst January January 2009 onwards) and the entry for the maturity on 12009 onwards) and the entry for the maturity on 1stst January 2010January 2010

Chapter 15-32


Nina Gera issued 100, Rs.5000, 9%, two years Nina Gera issued 100, Rs.5000, 9%, two years bonds on 1bonds on 1stst January 2008 at January 2008 at 108108. Interest is . Interest is payable semiannually on 1payable semiannually on 1stst July and 1 July and 1stst January each.January each.

Make all necessary journal entries for the bonds life Make all necessary journal entries for the bonds life periodperiod

Chapter 15-33


Bonds interest expense in the income Bonds interest expense in the income statement is higher than the nominal face statement is higher than the nominal face value interest in case of issue of bonds atvalue interest in case of issue of bonds at? Discount ?? Discount ?? Premium ?? Premium ?

Why (link with market rate of interest being the underlying Why (link with market rate of interest being the underlying cause of issue at discount or premium)cause of issue at discount or premium)

Part or all of this might go Part or all of this might go ‘over your heads’: Don’t worry, ‘over your heads’: Don’t worry, read the chapter and most of the things will get either read the chapter and most of the things will get either clearer or ….clearer or ….

Chapter 15-34

Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2010, for $92,639 (discount of $7,361). Interest is payable on July 1 and January 1. The bond discount amortization for each interest period is $736 ($7,361/10).

Illustration 15C-2

Amortizing Bond Discount

Straight-Line AmortizationStraight-Line AmortizationStraight-Line AmortizationStraight-Line Amortization

SO 9 Apply the straight-line method of SO 9 Apply the straight-line method of amortizing amortizing bond discount and bond bond discount and bond premium.premium.

Appendix 15C

Chapter 15-35

Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2010, for $92,639 (discount of $7,361). Interest is payable on July 1 and January 1. The bond discount amortization for each interest period is $736 ($7,361/10).

Journal entry on July 1, 2010, to record the interest payment and amortization of discount is as follows: Interest Expense 5,736

Cash 5,000

Discount on Bonds Payable 736

July 1

Amortizing Bond Discount

Straight-Line AmortizationStraight-Line AmortizationStraight-Line AmortizationStraight-Line Amortization

SO 9 Apply the straight-line method of SO 9 Apply the straight-line method of amortizing amortizing bond discount and bond bond discount and bond premium.premium.

Chapter 15-36

Redeeming Bonds at Maturity

Accounting for Bond RetirementsAccounting for Bond RetirementsAccounting for Bond RetirementsAccounting for Bond Retirements

SO 3 Describe the entries when bonds are redeemed or SO 3 Describe the entries when bonds are redeemed or converted.converted.

Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows:

Bond payable 100,000

Cash 100,000

Chapter 15-37

Redeeming Bonds before Maturity - Calling

When a company retires bonds before maturity, it is necessary to:

1. eliminate the carrying value of the bonds at the redemption date;

2. record the cash paid; and

3. recognize the gain or loss on redemption.The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.



Chapter 15-38 SO 3 Describe the entries when bonds are redeemed or SO 3 Describe the entries when bonds are redeemed or

converted.converted.

When bonds are redeemed before maturity, the gain or loss on redemption is the difference between the cash paid and the:

a. carrying value of the bonds.

b. face value of the bonds.

c. original selling price of the bonds.

d. maturity value of the bonds.

QuestionQuestion


Chapter 15-39

Illustration: Assume Candlestick, Inc. has sold its bonds at a premium. At the end of the eighth period, Candlestick retires these bonds at 103 after paying the semiannual interest. The carrying value of the bonds at the redemption date is $101,623. Candlestick makes the following entry to record the redemption at the end of the eighth interest period (January 1, 2014):


Premium on bonds payable 1,623

Loss on redemption 1,377

Cash 103,000



Chapter 15-40

Converting Bonds into Common Stock

Until conversion, the bondholder receives interest on the bond.

For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option.

Upon conversion, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized.



Chapter 15-41

Illustration: Assume that on July 1 Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion:


Common stock (2,000 x $10) 20,000

Paid-in capital in excess of par 80,000



Chapter 15-42

When bonds are converted into common stock:

a. a gain or loss is recognized.

b. the carrying value of the bonds is transferred to paid-in capital accounts.

c. the market price of the stock is considered in the entry.

d. the market price of the bonds is transferred to paid-in capital.

QuestionQuestion



Chapter 15-43

Long-Term Notes Payable / Serial Bonds

May be secured by a mortgage that pledges title to specific assets as security for a loan

Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of

1. interest on the unpaid balance of the loan and

2. a reduction of loan principal.

Companies initially record mortgage notes payable at face value recording the discount or premium as necessary.

Accounting for Other Long-Term Accounting for Other Long-Term LiabilitiesLiabilities(Serial Bonds)(Serial Bonds)

Accounting for Other Long-Term Accounting for Other Long-Term LiabilitiesLiabilities(Serial Bonds)(Serial Bonds)

SO 4 Describe the accounting for long-term notes payable.

Chapter 15-44

Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2010. The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows.

Accounting for Other Long-Term Accounting for Other Long-Term LiabilitiesLiabilitiesAccounting for Other Long-Term Accounting for Other Long-Term LiabilitiesLiabilities


Illustration 15-12

Chapter 15-45



Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2010. The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows.

Dec. 31 Cash 500,000Mortgage notes payable 500,000

Jun. 30 Interest expense 30,000Mortgage notes payable 3,231

Cash 33,231

Chapter 15-46

Each payment on a mortgage note payable consists of:

a. interest on the original balance of the loan.

b. reduction of loan principal only.

c. interest on the original balance of the loan and reduction of loan principal.

d. interest on the unpaid balance of the loan and reduction of loan principal.

QuestionQuestion



Chapter 15-47

Chapter 15-48

Lease Liabilities

A lease is a contractual arrangement between a lessor (owner of the property) and a lessee (renter of the property).

Lease AccountingLease AccountingLease AccountingLease Accounting

SO 5 Contrast the accounting for operating and capital leases.

Illustration 15-13

Chapter 15-49

The issue of how to report leases is the case of The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the . Although technically legal title may not pass, the benefits and rsisks from the use of the property do.benefits and rsisks from the use of the property do.

Capital Lease:Capital Lease:

A lease that transfers substantially all A lease that transfers substantially all of the risks and rewards of property of the risks and rewards of property ownership, should be capitalized (i.e. ownership, should be capitalized (i.e. regarded as purchase of property on regarded as purchase of property on credit)credit)



Chapter 15-50

Capital / Finance Lease

One or more of four criteria must be met:

1. Transfers ownership to the lessee.

2. Contains a bargain purchase option.

3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.

4. The present value of the minimum lease payments (excluding certain items) equals or exceeds 90 percent of the fair value of the leased property.

A lease which is not a Finance Lease is an Operating Lease which is a sort of usual rental of property concerned



Chapter 15-51

Operating LeaseOperating Lease Capital Lease / Finance Capital Lease / Finance LeaseLease

At InceptionAt Inception

No entryNo entry

At periodic paymentsAt periodic payments

Rent expenseRent expense xxx xxx

CashCash xxx xxx

At lease inceptionAt lease inception

Leased equipment xxxLeased equipment xxx

Lease liability Lease liability xxxxxx

At periodic paymentsAt periodic payments

Lease LiabilityLease Liabilityxxxxxx

Interest Exp.Interest Exp. xxxxxx

CashCash xxxxxx



Chapter 15-52

Exercise: Gonzalez Company decides to lease new equipment. The lease period is four years; the economic life of the leased equipment is estimated to be five years. The present value of the lease payments is $190,000, whichis equal to the fair market value of the equipment. There is no transfer of ownership during the lease term, nor is there any bargain purchase option.Instructions:

(a) What type of lease is this? Explain.

(b) Prepare the journal entry to record the lease.



Chapter 15-53

Exercise: (a) What type of lease is this? Explain.

Capitalization Criteria:Capitalization Criteria:

1.1. Transfer of ownershipTransfer of ownership

2.2. Bargain purchase optionBargain purchase option

3.3. Lease term => 75% of Lease term => 75% of economic life of leased economic life of leased propertyproperty

4.4. Present value of Present value of minimum lease payments minimum lease payments => 90% of FMV of => 90% of FMV of propertyproperty

NONO

NONO

Lease term

4 yrs.Economic life

5 yrs. YES

80%

YES - PV and FMV are the same.

Capital Lease?



Chapter 15-54

Exercise: (b) Prepare the journal entry to record the lease.



The portion of the lease liability expected to be paid in The portion of the lease liability expected to be paid in the next year is a current liability. The remainder is the next year is a current liability. The remainder is classified as a long-term liability.classified as a long-term liability.

Leased asset - equipment 190,000

Lease liability 190,000

Chapter 15-55

The lessee must record a lease as an asset if the lease:

a. transfers ownership of the property to the lessor.

b. contains any purchase option.

c. term is 75% or more of the useful life of the leased property.

d. payments equal or exceed 90% of the fair market value of the leased property.

QuestionQuestion



Chapter 15-56

Presentation

SO 6 Identify the methods for the presentation and analysis of long-term liabilities.

Statement Analysis and PresentationStatement Analysis and PresentationStatement Analysis and PresentationStatement Analysis and Presentation

Illustration 15-14

Chapter 15-57

Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Total debt

Total assets

Debt to total

assets

=

The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

1.1.



Chapter 15-58

Analysis of Long-Term Debt

Two ratios that provide information about debt-paying ability and long-run solvency are:

Income before income taxes and interest expense

Interest expense

Times interest earned

=

Indicates the company’s ability to meet interest payments as they come due.

2.2.



Chapter 15-59

Chapter 15-60

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chapter 15-1 long term liabilities 1. 1.quiz 2. 2.accounting for bonds (tfcs) 3. 3.accounting for...

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