Needles Powers Crosson Principles of Accounting 12e Long-Term Liabilities 14 C H A P T E R ©...

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Principles of Accounting

Long-Term Liabilities14C H A P T E R

LEARNING OBJECTIVES

LO1: Explain the concepts underlying long-term liabilities, and identify the types of long-term liabilities.

LO2: Describe the features of a bond issue and the major characteristics of bonds.

LO3: Record bonds issued at face value and at a discount or premium.

LO4: Use present values to determine the value of bonds. LO5: Amortize bond discounts and bond premiums using the

straight-line and effective interest methods. LO6: Account for the retirement of bonds and the conversion of

bonds into stocks. LO7: Record bonds issued between interest dates, and record

year-end adjustments. LO8: Explain and demonstrate the accounting issues related to

leases and pensions. LO9: Evaluate the decision to issue long-term debt, including

analyzing long-term debt.

SECTION 1: CONCEPTS

Recognition: the determination of when a business transaction should be recorded

Valuation: the process of assigning a monetary value to a business transaction and the resulting assets and liabilities

Classification: the process of assigning transactions to the appropriate accounts

Disclosure: presenting all information relevant to users’ understanding of the financial statements

Concepts Underlying Long-Term Liabilities

Long-term liabilities are debts and obligations that a company expects to satisfy in more than one year or beyond its normal operating cycle, whichever is longer.– Generally accepted accounting principles require that

long-term liabilities be recognized and recorded when an obligation occurs even though the obligation may not be due for many years.

– Long-term liabilities are generally valued at the amount of money needed to pay the debt or at the fair market value of the goods or services to be delivered.

– A liability is classified as long-term when it is due beyond one year or beyond the normal operating cycle.

– Because of the complex nature of many long-term liabilities, extensive disclosure in the notes to the financial statements are often required.

Types of Long-Term Debt

Bond payable—the most common type of long-term debt; a more complex financial instrument than a note; usually involves debt to many creditors

Note payable—a promissory note that represents a loan from a bank or other creditor

Mortgage—a long-term debt secured by real property; usually paid in equal monthly installments; each payment includes interest on the debt and a reduction in the debt (see next slide)

Monthly Payment Schedule on a $100,000, 9 Percent Mortgage

Mortgages Payable (slide 1 of 2)

Mortgages Payable (slide 2 of 2)

Other Long-Term Obligations

Long-term leases—When a lease has a term that corresponds closely to the life of the asset and, thus, is more like a purchase of an asset than a shorter-term lease, it is called a capital lease.

Pension liabilities—arise from contracts that require a company to make payments to its employees have they retire.

Other post-retirement benefits—arise from contracts that require a company to provide medical and other benefits to its employees after they retire.

Deferred income taxes—result from using different accounting methods to calculate income taxes on the income statement and income tax liability on the income tax return; this is considered a liability because these taxes will eventually have to be paid.

SECTION 2: ACCOUNTING APPLICATIONS

Record bonds issued at face value, at a discount, and at a premium

Value bonds Amortize bond discounts and bond premiums Record the retirement of bonds Record the conversion of bonds into stocks Record bonds issued between interest dates Record year-end adjustments Account for leases Account for pensions

The Nature of Bonds

A bond is a security, usually long-term, representing money that a corporation borrows from the investing public.– A bond entails a promise to repay the amount borrowed,

called the principal, on a specified date and to pay interest at a specified rate at specified times, usually semiannually.

– When a public corporation decides to issue bonds, it must receive approval from the SEC to borrow the funds. The SEC reviews the corporation’s financial health and the specific terms of the bond indenture, which is a contract that defines the rights, privileges, and limitations of the bondholders, including such things as the maturity date, interest payment dates, and the interest rate.

– As evidence of debt to the bondholders, the corporation provides each of them with a bond certificate.

Bond Issue: Prices and Interest Rates

A bond issue is the total value of bonds issued at one time. – Prices of bonds are stated in terms of a

percentage of the face value, or principal, of the bonds. A bond issue quoted at 103 ½ means that a

$1,000 bond costs $1,035 ($1,000 X 1.035) and, thus, sells at a premium.

When a bond sells at exactly 100, it is said to sell at face value (or par value).

A $1,000 bond quoted at 87.62 would be selling at a discount and would cost the buyer $876.20

Bond Issue: Prices and Interest Rates

The face interest rate is the fixed rate of interest paid to bondholders based on the face value of the bonds.

The market interest rate (or effective interest rate) is the rate of interest paid in the market on bonds of similar risk.– The market interest rate fluctuates daily. This fluctuation

may cause bonds to sell at either a discount or a premium.

A 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.

A 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.

Characteristics of Bonds(slide 1 of 2)

Unsecured bonds (or debenture bonds) are issued on the basis of a corporation’s general credit.

Secured bonds carry a pledge of certain corporate assets as a guarantee of repayment.

When all bonds of an issue mature at the same time, they are called term bonds.

When the bonds of an issue mature on different dates, they are called serial bonds.

Callable bonds give the issuer the right to buy back and retire the bonds before maturity at a specified call price, which is usually above face value.

Characteristics of Bonds(slide 2 of 2)

When a company retires a bond issue before its maturity date, it is called early extinguishment of debt.

Convertible bonds allow the bondholder to exchange a bond for a specified number of shares of common stock.

Registered bonds are issued in the names of the bondholders. The issuer keeps a record of the bondholders’ names and addresses and pays them interest by check.

Coupon bonds are not registered with the organization. They bear coupons that the bondholder removes on the interest payment dates and presents at a bank for collection.

Bonds Issued at Face Value(slide 1 of 2)

Bonds Issued at Face Value(slide 2 of 2)

Bonds Issued at a Discount(slide 1 of 2)

Bonds Issued at a Discount(slide 2 of 2)

Bonds Issued at a Premium(slide 1 of 2)

Bonds Issued at a Premium(slide 2 of 2)

Using Present Value to Value a Bond

A bond’s value is determined by summing the following two present value amounts:– a series of fixed interest payments– a single payment at maturity

The amount of interest a bond pays is fixed over its life. The market interest rate varies from day to day and is the

rate used to determine the bond’s present value.– Thus, the amount investors are willing to pay for a

bond varies because the bond’s present value changes as the market interest rate changes.

– The next slide shows how to calculate the present value of a bond when the market rate is above and below the face value.

Using Present Value to Value a $20,000, 9 Percent, Five-Year Bond

Market Value Above Face Rate

Market Value Below Face Rate

Amortizing a Bond Discount

The bond discount affects interest expense each year and should be amortized over the life of the bond issue. – In this way, the unamortized bond discount will decrease

gradually over time, and the carrying value of the bond issue (face value less unamortized discount) will increase gradually. By the maturity date, the carrying value of the bond issue will equal its face value, and the unamortized bond discount will be zero.

– The difference between the issue price and the face value must be added to the total interest payments to arrive at the actual interest expense.

– Zero coupon bonds do not require periodic interest payments. They are issued at a large discount because the only interest the buyer earns or the issuer pays is the discount.

Interest Expense for Bond Issued at a Discount

Amortizing a Bond Discount Using the Straight-Line Method (slide 1 of 3)

The straight-line method equalizes amortization of a bond discount for each interest period in the life of the bonds.

Effective Interest Method

When the effective interest method is used to compute the interest and amortization of a bond discount, a constant interest rate is applied to the carrying value of the bonds at the beginning of each interest period. – This constant rate is the market rate (i.e., the effective rate) at

the time the bonds were issued. – The amount amortized each period is the difference between the

interest computed by using the market rate and the actual interest paid to bondholders, as shown in the table on the next slide.

Interest and Amortization Table of a Bond Discount: Effective Interest Method (Exhibit 3)

Amortizing a Bond Discount Using the Effective Interest Method (slide 1 of 3)

Carrying Value and Interest Expense—Bonds Issued at a Discount

Amortizing a Bond Premium

Like a discount, a bond premium must be amortized over the life of the bonds so that it can be matched to its effects on interest expense during that period.

When bondholders pay more than face value for bonds, the premium represents an amount that they will not receive at maturity. – The premium is in effect a reduction, in advance, of

the total interest paid on the bonds over the life of the bond issue.

– The total interest expense over the issue’s life needs to be determined.

Interest Expense for a Bond Issued at a Premium

Amortizing a Bond Premium Using the Straight-Line Method (slide 1 of 3)

Interest and Amortization Table of a Bond Premium: Effective Interest Method (Exhibit 5)

Amortizing a Bond Premium Using the Effective Interest Method (slide 1 of 2)

With the effective interest method, the interest expense decreases slightly each period (see column B on the previous slide) because the amount of the bond premium amortized increases slightly (column D). This occurs because a fixed rate is applied each period to the gradually decreasing carrying value (column A).

Amortizing a Bond Premium Using the Effective Interest Method (slide 2of 2)

Carrying Value and Interest Expense—Bonds Issued at a Premium

Retirement of Bonds(slide 1 of 2)

Retiring a bond issue before its maturity date can be to a company’s advantage. For example, when interest rates drop, many companies refinance their bonds at the lower rate. Bonds may be retired either by calling the bonds or by buying them back from bondholders on the open market.

Retirement of Bonds(slide 2 of 2)

Conversion of Bonds(slide 1 of 2)

When a bondholder converts bonds to common stock, the company records the common stock at the carrying value of the bonds. The bond liability and the unamortized discount or premium are written off the books. For this reason, no gain or loss on the transaction is recorded.

Conversion of Bonds(slide 2 of 2)

Sale of Bonds Between Interest Dates

When corporations issue bonds between interest payment dates, they generally collect from the investors the interest that would have accrued for the partial period preceding the issue date.– At the end of the first interest period, they pay the interest

for the entire period. In other words, the interest collected when bonds are sold is returned to investors on the next interest payment date.

– There are two reasons for this procedure: It saves on the bookkeeping costs that would be required if the

interest due each bondholder had to be computed for a different time period.

When accrued interest is collected in advance, the amount is subtracted from the full interest paid on the interest payment date, and the resulting interest expense represents the amount for the time the money was borrowed.

Bonds Issued Between Interest Payment Dates

Interest Payment for Bonds Issued Between Interest Payment Dates (slide 1 of 2)

Interest Payment for Bonds Issued Between Interest Payment Dates (slide 2 of 2)

Exhibit 7

Year-End Accrual of Bond Interest Expense When Year-End Falls Between Interest Dates (slide 1 of 2)

Year-End Accrual of Bond Interest Expense When Year-End Falls Between Interest Dates (slide 2 of 2)

Payment of Interest When the Interest Payment Date Falls After Year-End Accrual (slide 1 of 2)

Payment of Interest When the Interest Payment Date Falls After Year-End Accrual (slide 2 of 2)

Long-Term Leases

A company can obtain an operating asset by:– Borrowing money and buying the asset– Renting the asset on a short-term lease (called an operating

lease) The risks of ownership of the asset remain with the lessor (the

owner), and lease is shorter than the asset’s useful life.

– Obtaining the asset on a long-term lease Accounting standards require that a long-term lease be treated as a

capital lease when it meets all of the following conditions:– It cannot be canceled.– Its duration is about the same as the useful life of the asset.– It stipulates that the lessee has the option to buy the asset at a

nominal price at the end of the lease. Structuring long-term leases in such a way that they do not appear

as liabilities on the balance sheet is called off-balance-sheet financing.

Payment Schedule on an 8 Percent Capital Lease

To illustrate capital leases, we will use Urban Manufacturing Company, which enters into a lease with an annual payment of $8,000 for six years, as shown below.

Capital Lease Recognition

Depreciation Recorded

Lease Payment

Pension Liabilities

A pension plan is a contract that requires a company to pay benefits to its employees after they retire.– The contributions from employer and employees are

usually paid into a pension fund, which is invested on behalf of the employees.

– There are two kinds of pension plans: Defined contribution plan—The employer makes a fixed

annual contribution, usually a percentage of the employee’s gross pay. Retirement payments vary depending on how much the employee’s retirement account earns.

Defined benefit plan—The employer contributes an amount annually to fund estimated future pension liability.

– Employers whose pension plans do not have sufficient assets to cover the present value of their pension obligations must record the amount of the shortfall as a liability.

Long-Term Liabilities on the Balance Sheet

SECTION 3: BUSINESS APPLICATIONS

Evaluate a company’s level of debt– Debt to equity ratio– Interest coverage ratio

Evaluating the Decision to Issue Long-Term Debt

Issuing common stock has two advantages over issuing long-term debt:– Permanent financing—Common stock does not have to be paid back.– Dividend payment is optional.

Issuing long-term debt, however, has the following advantages:– Common stockholders do not relinquish any of their control over the

company because bondholders and creditors do not have voting rights.– The interest on debt is tax-deductible, whereas dividends are not.– If a corporation earns more from the funds it raises by incurring long-

term debt than it pays in interest on the debt, the excess will increase its earnings for the stockholders. This concept is called financial leverage. Financial leverage is advantageous as long as a company is

able to make timely interest payments and repay the debt at maturity.

Because failure to do so can force a company into bankruptcy, a company must assess the financial risk involved.

Debt to Equity Ratio

To assess how much debt to carry, managers compute the debt to equity ratio, which shows the amount of debt a company carries in relation to its stockholders’ equity. The higher this ratio, the greater the financial risk.

Interest Coverage Ratio

The interest coverage ratio measures the degree of protection a company has from default on interest payments. The lower the ratio, the greater the financial risk.

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