Financial Accounting

Fundamentals

John J. Wild
2009 Edition
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 10

Accounting For
Long-Term Liabilities
 Conceptual Learning Objectives

C1: Explain the types and payment patterns of

notes.
C2: Appendix 10A: Explain and compute the
present value of an amount(s) to be paid at
a future date(s).
C3: Appendix 10C: Describe the accrual of
bond interest when bond payments do not
align with accounting periods.
C4: Appendix 10D: Describe the accounting
for leases and pensions.

10-3
 Analytical Learning Objectives

A1: Compare bond financing with stock

financing.
A2: Assess debt features and their
implications.
A3: Compute the debt-to-equity ratio and
explain its use.

10-4
 Procedural Learning Objectives

P1: Prepare entries to record bond

issuance and bond interest expense.
P2: Compute and record amortization of
bond discount.
P3: Compute and record amortization of
bond premium.
P4: Record the retirement of bonds.
P5: Prepare entries to account for notes.

10-5
A1
Advantages of Bonds

Bonds
Bonds do
do not
not affect
affect
stockholder
stockholder control.
control.

Interest
Interest on
on bonds
bonds is
is
tax
tax deductible.
deductible.

Bonds
Bonds can
can increase
increase
return
return on
on equity.
equity.

10-6
A1
Disadvantages of Bonds

Bonds
Bonds require
require payment
payment ofof both
both
periodic
periodic interest
interest and
and par
par value
value at
at
maturity.
maturity.

Bonds
Bonds can
can decrease
decrease return
return on
on
equity
equity when
when the
the company
company pays pays
more
more in
in interest
interest than
than itit earns
earns on
on
the
the borrowed
borrowed funds.
funds.
10-7
A1
Bond Issuing Procedures

. . .an investment firm

A company sells the called an underwriter.
bonds to. . . The underwriter sells
the bonds to. . .

A trustee
monitors
the bond
. . . investors issue.
10-8
A1
Basics of Bonds

Bond Interest Payments

Corporation Investors
Bond Interest Payments

Interest Payment =
Bond Issue
Bond Par Value  Stated Interest Rate
Date
10-9
P1
Issuing Bonds at Par

King
King Co.
Co. issues
issues the
the following
following bonds
bonds on
on
January
January 1,1, 2009
2009
Par
Par Value
Value == $1,000,000
$1,000,000
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2009
2009
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2028
2028 (20
(20 years)
years)
DR CR
Jan. 1 Cash 1,000,000
Bonds payable 1,000,000
Issued bonds at par
10-10
P1
Interest Expense on Bonds at Par

The
The entry
entry on
on June
June 30,
30, 2009,
2009, to
to record
record the the
first
first semiannual
semiannual interest
interest payment
payment isis .. .. ..
DR CR
June 30 Bond interest expense 50,000
Cash 50,000
Paid semi-annual interest

$1,000,000
$1,000,000 ×× 10%10% ×× ½
½ year
year == $50,000
$50,000
This
This entry
entry is
is made
made every
every six
six months
months until
until
the
the bonds
bonds mature.
mature.

10-11
P1
Issuing Bonds at Par

On
On Dec.
Dec. 31,
31, 2028,
2028, thethe bonds
bonds mature,
mature, King
King
Co.
Co. makes
makes the
the following
following entry
entry .. .. ..

DR CR
Dec. 31 Bonds payable 1,000,000
Cash 1,000,000
Paid bond principal at maturity
The debt has now been
extinguished.
10-12
P1
Bond Discount or Premium

Contract rate is: Bond sells:

Above market rate At a premium
Equal to market rate At par value
Below market rate At a discount

10-13
P2
Issuing Bonds at a Discount

Prepare
Prepare thethe entry
entry for
for Jan.
Jan. 1,
1, 2009,
2009, to
to record
record the
the
following
following bond
bond issue
issue by
by Rose
Rose Co.
Co.
Par
Par Value
Value == $1,000,000
$1,000,000
Issue
Issue Price
Price == 92.6405%
92.6405% of of par
par value
value
Stated
Stated Interest
Market
Interest Rate
Rate == 10%}
10% Bond will sell at a discount.
Market Interest
Interest Rate
Rate == 12%
12%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2009
2009
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2013
2013 (5(5 years)
years)

10-14
P2
Issuing Bonds at a Discount
Cash
Cash
Par
Par Value
Value Proceeds
Proceeds Discount
Discount
1,000,000 -- $$926,405
$$1,000,000 926,405 == $$ 73,595
73,595

$1,000,000 92.6405%
$1,000,000 92.6405%
Amortizing
Amortizing the
the discount
discount increases
increases
interest
interest expense
expense over
over the
the outstanding
outstanding life
life
of
of the
the bond.
bond.
10-15
P2
Issuing Bonds at a Discount

On
On Jan.
Jan. 1,
1, 2009,
2009, Rose
Rose Co.
Co. would
would record
record the
the
bond
bond issue
issue as
as follows.
follows.

DR CR
Jan. 1 Cash 926,405
Discount on bonds payable 73,595
Bonds payable 1,000,000
Sold bonds at a discount on issue date

Contra-Liability
Account
10-16
P2
Issuing Bonds at a Discount
Partial
Partial Balance
Balance Sheet
Sheet as
as of
of Jan.
Jan. 1,
1, 2009
2009

Long-term
Long-term Liabilities:
Liabilities: DR
DR CR
CR
Bonds
Bonds Payable
Payable $$1,000,000
1,000,000
Less:
Less: Discount
Discount on on Bonds
Bonds Payable
Payable 73,595
73,595 $$926,405
926,405

Maturity Value

Using
Using the
the straight-line
straight-line method,
method, the
the Carrying Value
discount
discount amortization
amortization will
will be
be $7,360
$7,360
every
every six
six months.
months.
$73,595
$73,595 ÷÷ 10
10 periods
periods == $7,360*
$7,360*
*(rounded)
*(rounded) 10-17
P2
Issuing Bonds at a Discount

Make
Make the
the following
following entry
entry every
every six
six months
months to
to
record
record the
the cash
cash interest
interest payment
payment and
and the
the
amortization
amortization of of the
the discount.
discount.
DR CR
June 30 Bond interest expense 57,360
Discount on bonds payable 7,360
Cash 50,000
Paid semi-annual interest and amortized discount

$73,595 ÷ 10 periods = $7,360 (rounded)

$1,000,000 × 10% × ½ = $50,000
10-18
 Straight-Line Amortization Table
P2
Interest Interest Discount Unamortized Carrying
Date Payment Expense Amortization* Discount Value
1/1/2009 $ 73,595 $ 926,405
6/30/2009 $ 50,000 $ 57,360 $ 7,360 66,235 933,765
12/31/2009 50,000 57,360 7,360 58,875 941,125
6/30/2010 50,000 57,360 7,360 51,515 948,485
12/31/2010 50,000 57,360 7,360 44,155 955,845
6/30/2011 50,000 57,360 7,360 36,795 963,205
12/31/2011 50,000 57,360 7,360 29,435 970,565
6/30/2012 50,000 57,360 7,360 22,075 977,925
12/31/2012 50,000 57,360 7,360 14,715 985,285
6/30/2013 50,000 57,360 7,360 7,355 992,645
12/31/2013 50,000 57,355 7,355 0 1,000,000
$ 500,000 $ 573,595 $ 73,595
* Rounded.
10-19
P2 Straight-Line and Effective Interest
Methods
Both methods report the same amount of
interest expense over the life of the bond.

60,000
59,000
Straight-Line Method
58,000
57,000
12/31/08 12/31/09 12/31/10Interest
Effective 12/31/11
56,000
Straight-Line Method 57,360 57,360 Method
57,360 57,360
55,000
Effective Interest Method 55,919 56,650 57,472 58,396
54,000
2009 2010 2011 2012

10-20
P3
Issuing Bonds at a Premium

Prepare
Prepare the
the entry
entry for
for Jan.
Jan. 1,
1, 2009,
2009, toto record
record the
the
following
following bond
bond issue
issue byby Rose
Rose Co.
Co.
Par
Par Value
Value == $1,000,000
$1,000,000
Issue
Issue Price
Price == 108.1145%
108.1145% of of par
par value
value
Stated
Stated Interest
Interest Rate
Rate == 10%
10% Bond will sell at a
Market
Market Interest
Interest Rate
Rate == 8%8% } premium.
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,1, 2009
2009
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2013
2013 (5(5 years)
years)
10-21
P3
Issuing Bonds at a Premium
Cash
Cash
Proceeds
Proceeds Par
Par Value
Value Premium
Premium
$$1,081,145
1,081,145 -- $$1,000,000
1,000,000 == $$ 81,145
81,145

$1,000,000 
$1,000,000 108.1145%
108.1145%

Amortizing
Amortizing the
the premium
premium decreases
decreases interest
interest
expense
expense over
over the
the life
life of
of the
the bond.
bond.

10-22
P3
Issuing Bonds at a Premium

On
On Jan.
Jan. 1,
1, 2009,
2009, Rose
Rose Co.
Co. would
would record
record the
the
bond
bond issue
issue as
as follows.
follows.
DR CR
Jan. 1 Cash 1,081,145
Premium on bonds payable 81,145
Bonds payable 1,000,000
Issued bonds at a premium on issue date

Adjunct-Liability
Adjunct-Liability
(or
(or accretion)
accretion)
Account
Account
10-23
P3
Issuing Bonds at a Premium
Partial
Partial Balance
Balance Sheet
Sheet as
as of
of Jan.
Jan. 1,
1, 2009
2009

Long-term
Long-term Liabilities:
Liabilities: DR
DR CR
CR
Bonds
Bonds Payable
Payable $$1,000,000
1,000,000
Add:
Add: Premium
Premium on on Bonds
Bonds Payable
Payable 81,145
81,145 $$ 1,081,145
1,081,145

Using
Using the
the straight-line
straight-line method,
method, the
the premium
premium
amortization
amortization will
will be
be $8,115
$8,115 every
every six
six months.
months.
$81,145
$81,145 ÷÷ 10
10 periods
periods == $8,115
$8,115 (rounded)
(rounded)

10-24
P3
Issuing Bonds at a Premium
This
This entry
entry is
is made
made every
every six
six months
months to
to
record
record the
the cash
cash interest
interest payment
payment and
and the
the
amortization
amortization ofof the
the premium.
premium.

Premium on bonds payable 8,115

Cash 50,000
Paid semi-annual interest and
amortized premium

$81,145
$81,145 ÷÷ 10
10 periods
periods == $8,115
$8,115 (rounded)
(rounded)

$1,000,000
$1,000,000 ×× 10%
10% ×× ½
½ == $50,000
$50,000
10-25
 Straight-Line Amortization Table
P3
Interest Interest Premium Unamortized Carrying
Date Payment Expense Amortization* Premium Value
1/1/2009 $ 81,145 $ 1,081,145
6/30/2009 $ 50,000 $ 41,885 $ 8,115 73,030 1,073,030
12/31/2009 50,000 41,885 8,115 64,915 1,064,915
6/30/2010 50,000 41,885 8,115 56,800 1,056,800
12/31/2010 50,000 41,885 8,115 48,685 1,048,685
6/30/2011 50,000 41,885 8,115 40,570 1,040,570
12/31/2011 50,000 41,885 8,115 32,455 1,032,455
6/30/2012 50,000 41,885 8,115 24,340 1,024,340
12/31/2012 50,000 41,885 8,115 16,225 1,016,225
6/30/2013 50,000 41,885 8,115 8,110 1,008,110
12/31/2013 50,000 41,890 8,110 0 1,000,000
$ 500,000 $ 418,855 $ 81,145
* Rounded.

10-26
C3
Accruing Bond Interest Expense
End of
accounting
Interest Payment Dates period
Jan. 1 Apr. 1 Oct. 1 Dec. 31
3 months’
accrued interest

At
At year-end,
year-end, an
an adjusting
adjusting entry
entry isis necessary
necessary to
to
recognize
recognize bond
bond interest
interest expense
expense accrued
accrued since
since
the
the most
most recent
recent interest
interest payment.
payment.

10-27
C2
Present Value of a Discount Bond

Calculate
Calculate the
the issue
issue price
price of
of Rose
Rose Inc.’s
Inc.’s bonds.
bonds.
Par
Par Value
Value == $1,000,000
$1,000,000
Issue
Issue Price
Price == ??
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Market
Market Interest
Interest Rate
Rate == 12%
12%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2009
2009
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2013
2013 (5
(5 years)
years)

10-28
C2

Present Value of a Discount Bond

Table Present
Cash Flow Table Value Amount Value
Par value of the bond PV of $1 0.5584 $ 1,000,000 $ 558,400

Interest (annuity) PV of an
Annuity of $1 7.3601 50,000 368,005
Price of bond $ 926,405

1.
1. Semiannual
Semiannual rate
rate == 6%
6% (Market
(Market rate
rate 12%
12% ÷÷ 2)
2)
2.
2. Semiannual
Semiannual periods
periods == 10
10 (Bond
(Bond life
life 55 years
years ×× 2)
2)

$1,000,000 × 10% × ½ = $50,000

10-29
P4
Bond Retirement

• At Maturity DR CR
Dec. 31 Bonds payable 1,000,000
Cash 1,000,000
Retirement of bonds at maturity

• Before Maturity
• Carrying Value > Retirement Price = Gain
• Carrying Value < Retirement Price = Loss

10-30
A2
Types of Bonds

Secured
Secured and
and Convertible
Convertible
Unsecured
Unsecured and
and Callable
Callable

Term
Term and
and Registered
Registered
Serial
Serial and
and Bearer
Bearer

10-31
P4

Bond Retirement
 The carrying value of the bond at maturity
should equal its par value.
 Sometimes bonds are retired prior to their
maturity.
 Two common ways to retire bonds are
through the exercise of a callable option or
through purchasing them on the open
market.
 Callable bonds present several accounting
issues including calculating gains and
losses.

10-32
C1
Long-Term Notes Payable

Cash

Company Note
Note Payable
Payable Lender

When is the repayment of the principal

and interest going to be made?

Note Date Note Maturity

Date
10-33
C1

Long-Term Notes Payable

Single Payment of
Principal plus Interest

Company Lender
Single Payment of
Principal plus
Interest

Note Date Note Maturity

Date
10-34
C1

Long-Term Notes Payable

Regular Payments of
Principal plus Interest
Company Lender
Regular Payments of Principal plus Interest

Payments can either be

Note Date equal principal payments Note Maturity
plus interest or equal Date
payments. 10-35
C1/P5 Installment Notes with Equal
Principal Payments
$16,000 Annual
$14,000 payments
$12,000 decrease.
$10,000
Interest
$8,000
Principal
$6,000
$4,000
$2,000
$-
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

The
The principal
principal payments
payments are
are $10,000
$10,000 each
each year.
year.
Interest
Interest expense
expense decreases
decreases each
each year.
year.
10-36
C1 Installment Notes with Equal
Payments

$14,000 Annual
$12,000 payments are
$10,000
constant.
$8,000 Interest
$6,000 Principal
$4,000
$2,000
$-
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

The
The principal
principal payments
payments increase
increase each
each year.
year.
Interest
Interest expense
expense decreases
decreases each
each year.
year.
10-37
C1
Mortgage Notes and Bonds


 AA legal
legal agreement
agreement that
that helps
helps protect
protect the
the
lender
lender ifif the
the borrower
borrower fails
fails to
to make
make the
the
required
required payments.
payments.

 Gives
Gives the
the lender
lender the
the right
right to
to be
be paid
paid out
out of
of
the
the cash
cash proceeds
proceeds from
from the
the sale
sale of
of the
the
borrower’s
borrower’s assets
assets specifically
specifically identified
identified in
in
the
the mortgage
mortgage contract.
contract.

10-38
A3
Debt-to-Equity Ratio

Debt-to- Total Liabilities

=
Equity Ratio Total Equity

This ratio helps investors determine the risk of

investing in a company by dividing its total liabilities
by total equity.

10-39
C3 Issuing Bonds Between
Interest Dates
Apr. 1, 2009 June 30, 2009
Jan. 1, 2009 Bond Issue First Interest
Bond Date Date Payment

Accrued interest

Investor pays bond purchase

price + accrued interest.

10-40
C3 Issuing Bonds Between
Interest Dates
Apr. 1, 2009 June 30, 2009
Jan. 1, 2009 Bond Issue First Interest
Bond Date Date Payment

Accrued interest Earned interest

Investor
receives 6
months’
interest.

10-41
C3 Issuing Bonds Between
Interest Dates
Prepare
Prepare the
the entry
entry to
to record
record the
the following
following bond
bond
issue
issue by
by King
King Co.
Co. onon Apr.
Apr. 1,
1, 2009.
2009.
Par
Par Value
Value == $1,000,000
$1,000,000
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Market
Market Interest
Interest Rate
Rate == 10%
10%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2009
2009
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2013
2013 (5
(5 years)
years)

10-42
C3 Issuing Bonds Between Interest
Dates
At the date of issue the following entry is made:
DR CR
Apr. 1 Cash 1,025,000
Interest payable 25,000
Bonds payable 1,000,000
Issued bonds at par plus accrued interest

The first interest payment on June 30, 2009 is:

DR CR
June 30 Interest payable 25,000
Bond interest expense 25,000
Cash 50,000
Paid semi-annual interest
10-43
End of Chapter 10

10-44