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10
Liabilities
Chapter
STUDY
OBJECTIVES
After studying this chapter, you should be
able to:
1 Explain a current liability, and identify
the major types of current liabilities.
2 Describe the accounting for notes
payable.
3 Explain the accounting for other current
liabilities.
4 Explain why bonds are issued, and
identify the types of bonds.
5 Prepare the entries for the issuance of
bonds and interest expense.
6 Describe the entries when bonds are
redeemed or converted.
7 Describe the accounting for long-term
notes payable.
8 Identify the methods for the presentation
and analysis of long-term liabilities.
✓
✓ The Navigator
Scan Study Objectives
■
Read Feature Story
■
Read Preview
■
Read text and answer
p. 453
p. 465
■
■
p. 458
■
Work Comprehensive
Do it!
p. 461
Do it!
■
p. 463
p. 469
■
■
Review Summary of Study Objectives
■
Answer Self-Study Questions
■
Complete Assignments
■
The Navigator
Feature Story
FINANCING HIS DREAMS
What would you do if you had a great idea for a new product, but couldn’t
come up with the cash to get the business off the ground? Small businesses
often cannot attract investors. Nor can they obtain traditional debt financing
through bank loans or bond issuances. Instead, they often resort to unusual,
and costly, forms of nontraditional financing.
Such was the case for Wilbert Murdock. Murdock grew up in a New York
housing project, and always had great ambitions. This ambitious spirit led him
into some business ventures that failed: a medical diagnostic tool, a device to
eliminate carpal-tunnel syndrome, custom-designed sneakers, and a device to
keep people from falling asleep while driving.
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Another idea was computerized golf clubs that analyze a
golfer’s swing and provide
immediate feedback. Murdock
saw great potential in the
idea: Many golfers are willing
to shell out considerable sums
of money for devices that
might improve their game.
But Murdock had no cash to
develop his product, and
banks and other lenders had
shied away. Rather than give
up, Murdock resorted to credit cards—in a big way. He quickly owed $25,000
to credit card companies.
While funding a business with credit cards might sound unusual, it isn’t. A
recent study found that one-third of businesses with fewer than 20 employees financed at least part of their operations with credit cards. As Murdock
explained, credit cards are an appealing way to finance a start-up because
“credit-card companies don’t care how the money is spent.” However, they
do care how they are paid. And so Murdock faced high interest charges and
a barrage of credit card collection letters.
Murdock’s debt forced him to sacrifice nearly everything in order to keep
his business afloat. His car stopped running, he barely had enough money
to buy food, and he lived and worked out of a dimly lit apartment in his
mother’s basement. Through it all he tried to maintain a positive spirit, joking
that, if he becomes successful, he might some day get to appear in an
American Express commercial.
Source: Rodney Ho, “Banking on Plastic: To Finance a Dream, Many Entrepreneurs Binge
on Credit Cards,” Wall Street Journal, March 9, 1998, p. A1.
✓
The Navigator
Inside Chapter 10…
• Taxes Are the Largest Slice of the Pie
• When to Go Long-Term
(p. 457)
• Search for Your Best Rate
• “Covenant-Lite” Debt
(p. 450)
(p. 465)
(p. 467)
• All About You: Your Boss Wants to Know
If You Ran Today (p. 468)
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Preview of Chapter 10
Inventor-entrepreneur Wilbert Murdock, as you can tell from the Feature Story, had to use multiple credit
cards to finance his business ventures. Murdock’s credit card debts would be classified as current liabilities
because they are due every month. Yet by making minimal payments and paying high interest each month,
Murdock used this credit source long-term. Some credit card balances remain outstanding for years as they
accumulate interest.
In Chapter 1, we defined liabilities as creditors’ claims on total assets and as existing debts and obligations.
These claims, debts, and obligations must be settled or paid at some time in the future by the transfer of
assets or services. The future date on which they are due or payable (maturity date) is a significant feature
of liabilities. This “future date” feature gives rise to two basic classifications of liabilities: (1) current liabilities
and (2) long-term liabilities. Our discussion in this chapter is divided into these two classifications.
The content and organization of Chapter 10 are as follows.
Liabilities
Current Liabilities
Long-Term Liabilities
Notes payable
Sales taxes payable
Payroll and payroll taxes
Unearned revenues
Current maturities of long-term
debt
• Statement presentation and
analysis
• Bond basics
• Accounting for bond issues
• Accounting for bond
retirements
• Accounting for long-term notes
payable
• Statement presentation and
analysis
•
•
•
•
•
✓
SECTION 1
The Navigator
Current Liabilities
WHAT IS A CURRENT LIABILITY?
As explained in Chapter 4, a current liability is a debt with two key features:
(1) The company reasonably expects to pay the debt from existing
Explain a current liability, and
current
assets or through the creation of other current liabilities. (2) The
identify the major types of
company will pay the debt within one year or the operating cycle,
current liabilities.
whichever is longer. Debts that do not meet both criteria are classified as
long-term liabilities. Most companies pay current liabilities within one year out of
current assets, rather than by creating other liabilities.
Companies must carefully monitor the relationship of current liabilities to current assets. This relationship is critical in evaluating a company’s short-term debtpaying ability. A company that has more current liabilities than current assets may
not be able to meet its current obligations when they become due.
Current liabilities include notes payable, accounts payable, and unearned
revenues. They also include accrued liabilities such as taxes, salaries and wages, and
interest payable. In previous chapters we explained the entries for accounts
payable and adjusting entries for some current liabilities. In the following sections,
we discuss other types of current liabilities.
STUDY OBJECTIVE 1
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Notes Payable
Companies record obligations in the form of written promissory notes,
STUDY OBJECTIVE 2
called notes payable. Notes payable are often used instead of accounts Describe the accounting for
payable because they give the lender formal proof of the obligation in case notes payable.
legal remedies are needed to collect the debt. Notes payable usually
require the borrower to pay interest. Companies frequently issue them to meet
short-term financing needs.
Notes are issued for varying periods. Those due for payment within one year of
the balance sheet date are usually classified as current liabilities.
To illustrate the accounting for notes payable, assume that First National Bank
agrees to lend $100,000 on March 1, 2011, if Cole Williams Co. signs a $100,000,
12%, four-month note. With an interest-bearing promissory note, the amount of
assets received upon issuance of the note generally equals the note’s face value.
Cole Williams Co. therefore will receive $100,000 cash and will make the following
journal entry.
A
Mar. 1
Cash
Notes Payable
(To record issuance of 12%, 4-month
note to First National Bank)
L
SE
100,000
100,000
100,000
100,000
Cash Flows
100,000
Interest accrues over the life of the note, and the company must periodically
record that accrual. If Cole Williams Co. prepares financial statements on June 30,
it makes an adjusting entry at June 30 to recognize interest expense and interest
payable of $4,000 ($100,000 12% 4/12). Illustration 10-1 shows the formula for
computing interest, and its application to Cole Williams Co.’s note.
Illustration 10-1
Formula for computing
interest
Annual
Time in
Face Value
ⴛ Interest ⴛ Terms of ⴝ Interest
of Note
Rate
One Year
$100,000
12%
4/12
$4,000
Cole Williams makes an adjusting entry as follows:
A
June 30
Interest Expense
Interest Payable
(To accrue interest for 4 months on
First National Bank note)
L
SE
4,000 Exp
4,000
4,000
In the June 30 financial statements, the current liabilities section of the balance
sheet will show notes payable $100,000 and interest payable $4,000. In addition,
the company will report interest expense of $4,000 under “Other expenses and
losses”in the income statement. If Cole Williams Co. prepared financial statements
monthly, the adjusting entry at the end of each month would have been $1,000
($100,000 12% 1/12).
At maturity (July 1, 2011), Cole Williams Co. must pay the face value of the
note ($100,000) plus $4,000 interest ($100,000 12% 4/12). It records payment
of the note and accrued interest, as shown on the next page.
4,000
Cash Flows
no effect
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Chapter 10 Liabilities
L
SE
July 1
100,000
4,000
104,000
Cash Flows
104,000
Notes Payable
Interest Payable
Cash
(To record payment of First National
Bank interest-bearing note and accrued
interest at maturity)
100,000
4,000
104,000
Sales Taxes Payable
As a consumer, you know that many of the products you purchase at retail
stores are subject to sales taxes. Many states also are now collecting sales
Explain the accounting for other
taxes on purchases made on the Internet. Sales taxes are expressed as a
current liabilities.
stated percentage of the sales price. The retailer collects the tax from the
customer when the sale occurs. Periodically (usually monthly), the retailer remits
the collections to the state’s department of revenue.
Under most state sales tax laws, the selling company must ring up separately on
the cash register the amount of the sale and the amount of the sales tax collected.
(Gasoline sales are a major exception.) The company then uses the cash register
readings to credit Sales and Sales Taxes Payable. For example, if the March 25 cash
register reading for Cooley Grocery shows sales of $10,000 and sales taxes of $600
(sales tax rate of 6%), the journal entry is:
STUDY OBJECTIVE 3
A
L
SE
10,600
Mar. 25
10,000 Rev
600
Cash Flows
10,600
HELPFUL HINT
Alternatively, Cooley
could find the tax by
multiplying sales by
the sales tax rate
($10,000 ⴛ .06).
Cash
Sales
Sales Taxes Payable
(To record daily sales and sales taxes)
10,600
10,000
600
When the company remits the taxes to the taxing agency, it debits Sales Taxes
Payable and credits Cash. The company does not report sales taxes as an expense.
It simply forwards to the government the amount paid by the customers. Thus,
Cooley Grocery serves only as a collection agent for the taxing authority.
Sometimes companies do not ring up sales taxes separately on the cash register. To determine the amount of sales in such cases, divide total receipts by 100%
plus the sales tax percentage. To illustrate, assume that in the above example
Cooley Grocery rings up total receipts of $10,600. The receipts from the sales are
equal to the sales price (100%) plus the tax percentage (6% of sales), or 1.06 times
the sales total. We can compute the sales amount as follows.
$10,600 1.06 $10,000
Thus, Cooley Grocery could find the sales tax amount it must remit to the state
($600) by subtracting sales from total receipts ($10,600 $10,000).
Payroll and Payroll Taxes Payable
Every employer incurs liabilities relating to employees’ salaries and wages. One is
the amount of wages and salaries owed to employees—wages and salaries payable.
Another is the amount required by law to be withheld from employees’ gross pay.
Until a company remits these withholding taxes (federal and state income taxes,
and Social Security taxes) to the governmental taxing authorities, they are credited
to appropriate liability accounts. For example, if a corporation withholds taxes
from its employees’ wages and salaries, it would record accrual and payment of a
$100,000 payroll, as shown on the next page.
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449
What Is a Current Liability?
Mar. 7
Salaries and Wages Expense
FICA Taxes Payable1
Federal Income Taxes Payable
State Income Taxes Payable
Salaries and Wages Payable
(To record payroll and withholding
taxes for the week ending March 7)
100,000
7,650
21,864
2,922
67,564
A
L
SE
100,000
7,650
21,864
2,922
67,564
Cash Flows
no effect
Mar. 11
Salaries and Wages Payable
Cash
(To record payment of the March 7
payroll)
67,564
67,564
A
L
SE
67,564
67,564
Cash Flows
67,564
Illustration 10-2 summarizes the types of payroll deductions.
Mandatory
Deductions
Federal Income Tax
FICA Taxes
State and City Income Taxes
Gross Pay
Insurance and Pensions
Charity
Net Pay
Union Dues
Voluntary Deductions
Also, with every payroll, the employer incurs liabilities to pay various payroll
taxes levied upon the employer. These payroll taxes include the employer’s share
of Social Security taxes and the state and federal unemployment taxes. Based on
the $100,000 payroll in the previous example, the company would make the following entry to record the employer’s expense and liability for these payroll taxes.
Mar. 7
1
Payroll Tax Expense
FICA Taxes Payable
Federal Unemployment Taxes Payable
State Unemployment Taxes Payable
(To record employer’s payroll taxes on
March 7 payroll)
Illustration 10-2
Payroll deductions
A
L
SE
13,850
13,850
7,650
800
5,400
In 2009 FICA includes 6.2% of the first $106,800 for Old-Age, Survivors, and Disability Insurance
(OASDI) and 1.45% of all wages for Hospital Insurance (HI).
7,650
800
5,400
Cash Flows
no effect
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Chapter 10 Liabilities
Illustration 10-3
Employer payroll taxes
Illustration 10-3 shows the types of taxes levied on employers.
FICA Taxes
Federal Unemployment Taxes
State Unemployment Taxes
Computation
Based
on Wages
Companies classify the payroll and payroll tax liability accounts as current
liabilities because these amounts must be paid to employees or remitted to taxing
authorities in the near term. Taxing authorities impose substantial fines and penalties on employers if the withholding and payroll taxes are not computed correctly
and paid on time.
ACCOUNTING ACROSS THE ORGANIZATION
Taxes Are the Largest Slice of the Pie
In 2008, Americans worked 74 days to afford their federal taxes and 39 more
days to afford state and local taxes, according to the Tax Foundation. Each year
this foundation calculates the mathematical average of tax collections in the United States,
using a formula that divides the year’s total tax collections (federal, state, and local taxes) by
all income earned (the “national income”). The resulting national “tax burden”varies each
year, and the tax burden also varies by state.
National taxation in 2008 was a bigger burden than average expenditures on housing and
household operation (60 days), health and medical care (50 days), food (35 days), transportation (29 days), recreation (21 days), or clothing and accessories (13 days).
Source: www.taxfoundation.org/taxfreedomday (accessed June 2008). For a map of tax burden by states, see Figure 6
at that site.
If the information on 2008 taxation depicted your spending patterns, on what date
(starting on January 1) will you have earned enough to pay all of your taxes? This date
is often referred to as Tax Freedom Day.
Unearned Revenues
A magazine publisher, such as Sports Illustrated, receives customers’ checks when
they order magazines. An airline company, such as American Airlines, receives cash
when it sells tickets for future flights.Through these transactions, both companies have
incurred unearned revenues—revenues that are received before the company delivers
goods or provides services. How do companies account for unearned revenues?
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1. When a company receives the advance payment, it debits Cash, and credits a
current liability account identifying the source of the unearned revenue.
2. When the company earns the revenue, it debits the Unearned Revenue
account, and credits an earned revenue account.
To illustrate, assume that Superior University sells 10,000 season football
tickets at $50 each for its five-game home schedule. The university makes the
following entry for the sale of season tickets:
A
Aug. 6
Cash
Unearned Football Ticket Revenue
(To record sale of 10,000 season tickets)
L
SE
SE
500,000
500,000
500,000
500,000
Cash Flows
500,000
As the school completes each of the five home games, it earns one-fifth of the
revenue. The following entry records the revenue earned.
A
Sept. 7
Unearned Football Ticket Revenue
Football Ticket Revenue
(To record football ticket revenue
earned)
100,000
100,000
L
100,000
100,000 Rev
Cash Flows
no effect
Organizations report any balance in an unearned revenue account (in
Unearned Football Ticket Revenue, for example) as a current liability in the balance sheet. As they earn the revenue, a transfer from unearned revenue to earned
revenue occurs. Unearned revenue is material for some companies. In the airline
industry, for example, tickets sold for future flights represent almost 30% of total
current liabilities. At United Air Lines, unearned ticket revenue is the largest current liability, recently amounting to over $1.6 billion.
Illustration 10-4 shows specific unearned and earned revenue accounts used in
selected types of businesses.
Account Title
Type of
Business
Unearned Revenue
Earned Revenue
Airline
Magazine publisher
Hotel
Insurance company
Unearned Passenger Ticket Revenue
Unearned Subscription Revenue
Unearned Rental Revenue
Unearned Premium Revenue
Passenger Revenue
Subscription Revenue
Rental Revenue
Premium Revenue
Current Maturities of Long-Term Debt
Companies often have a portion of long-term debt that comes due in the current
year.That amount is considered a current liability. For example, assume that Wendy
Construction issues a five-year interest-bearing $25,000 note on January 1, 2011.
Each January 1, starting January 1, 2012, $5,000 of the note is due to be paid. When
Wendy Construction prepares financial statements on December 31, 2011, it should
report $5,000 as a current liability. It would report the remaining $20,000 on the
note as a long-term liability. Current maturities of long-term debt are often termed
long-term debt due within one year.
It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. The company will recognize the proper statement classification of each balance sheet account when it prepares the balance sheet.
Illustration 10-4
Unearned and earned
revenue accounts
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Chapter 10 Liabilities
STATEMENT PRESENTATION AND ANALYSIS
Presentation
As indicated in Chapter 4, current liabilities are the first category under liabilities
on the balance sheet. Each of the principal types of current liabilities is listed separately. In addition, companies disclose the terms of notes payable and other key
information about the individual items in the notes to the financial statements.
Companies seldom list current liabilities in the order of liquidity. The reason is
that varying maturity dates may exist for specific obligations such as notes payable.
A more common method of presenting current liabilities is to list them by order of
magnitude, with the largest ones first. Or, as a matter of custom, many companies
show notes payable first, and then accounts payable, regardless of amount. Then
the remaining current liabilities are listed by magnitude. (Use this approach in your
homework.) The following adapted excerpt from the balance sheet of Caterpillar
Inc. illustrates its order of presentation.
Illustration 10-5
Balance sheet presentation
of current liabilities
CATERPILLAR INC.
Balance Sheet
(partial)
(in millions)
Assets
Current assets
Property, plant and equipment (net)
Other long-term assets
Total assets
$20,856
7,682
14,553
$43,091
Liabilities and Stockholders’ Equity
HELPFUL HINT
For other examples of
current liabilities sections,
refer to the PepsiCo and
Coca-Cola balance sheets
in Appendices A and B.
Current liabilities
Short-term borrowings (notes payable)
Accounts payable
Accrued expenses
Accrued wages, salaries, and employee benefits
Customer advances
Dividends payable
Deferred and current income taxes payable
Long-term debt due within one year
Total current liabilities
Noncurrent liabilities
Total liabilities
Stockholders’ equity
Total liabilities and stockholders’ equity
$ 4,157
3,990
1,847
1,730
555
141
259
3,531
16,210
19,414
35,624
7,467
$43,091
Analysis
Use of current and noncurrent classifications makes it possible to analyze a company’s liquidity. Liquidity refers to the ability to pay maturing obligations and meet
unexpected needs for cash. The relationship of current assets to current liabilities is
critical in analyzing liquidity. We can express this relationship as a dollar amount
(working capital) and as a ratio (the current ratio).
The excess of current assets over current liabilities is working capital.
Illustration 10-6 shows the formula for the computation of Caterpillar’s working
capital (dollar amounts in millions).
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453
Illustration 10-6
Working capital formula and
computation
Current
Current
Working
ⴚ
ⴝ
Assets
Liabilities
Capital
$20,856 $16,210 $4,646
As an absolute dollar amount, working capital offers limited informational
value. For example, $1 million of working capital may be far more than needed for a
small company but be inadequate for a large corporation.Also, $1 million of working
capital may be adequate for a company at one time but inadequate at another time.
The current ratio permits us to compare the liquidity of different-sized companies and of a single company at different times. The current ratio is calculated as
current assets divided by current liabilities. The formula for this ratio is illustrated
below, along with its computation using Caterpillar’s current asset and current liability data (dollar amounts in millions).
Illustration 10-7
Current ratio formula and
computation
Current ⴜ Current ⴝ Current
Assets
Liabilities
Ratio
$20,856 $16,210 1.29:1
Historically, companies and analysts considered a current ratio of 2:1 to be the
standard for a good credit rating. In recent years, however, many healthy companies have maintained ratios well below 2:1 by improving management of their
current assets and liabilities. Caterpillar’s ratio of 1.29:1 is adequate but certainly
below the standard of 2:1.
before you go on...
Do it!
You and several classmates are studying for the next accounting examination.
They ask you to answer the following questions: (1) How is the sales tax amount determined
when the cash register total includes sales taxes? (2) What is payroll tax expense related to Social
Security taxes if salaries and wages for the week are $10,000?
Solution
1. First, divide the total proceeds by 100% plus the sales tax percentage to find the sales amount.
Second, subtract the sales amount from the total proceeds to determine the sales taxes.
2. Social Security taxes (FICA) $10,000 7.65% $765.
Related exercise material: BE10-1, BE10-2, BE10-3, BE10-4, BE10-5, BE10-6, E10-1, E10-2, E10-3, E10-4,
E10-5, E10-6, E10-7, and Do it! 10-1.
✓
SECTION 2
Current Liabilities
Action Plan
• Divide total receipts by 100%
plus the tax rate to determine
sales; then subtract sales from
the total receipts.
• Multiply the FICA tax rate times
the salary and wage expense
amount.
The Navigator
Long-Term Liabilities
Long-term liabilities are obligations that are expected to be paid after one year. In
this section we will explain the accounting for the principal types of obligations
reported in the long-term liability section of the balance sheet. These obligations
often are in the form of bonds or long-term notes.
BOND BASICS
Bonds are a form of interest-bearing notes payable.To obtain large amounts
of long-term capital, corporate management usually must decide whether to
issue common stock (equity financing) or bonds. Bonds offer three advantages over common stock, as shown in Illustration 10-8 (page 454).
STUDY OBJECTIVE 4
Explain why bonds are issued,
and identify the types of bonds.
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Chapter 10 Liabilities
Illustration 10-8
Advantages of bond
financing over common
stock
Bond Financing
Advantages
1. Stockholder control is not affected.
Bondholders do not have voting rights, so current owners
(stockholders) retain full control of the company.
2. Tax savings result.
Bond interest is deductible for tax purposes; dividends on
stock are not.
3. Earnings per share may be higher.
Although bond interest expense reduces net income, earnings
per share on common stock often is higher under bond financing
because no additional shares of common stock are issued.
As the illustration shows, one reason to issue bonds is that they do not affect
stockholder control. Because bondholders do not have voting rights, owners can
raise capital with bonds and still maintain corporate control. In addition, bonds are
attractive to corporations because the cost of bond interest is tax-deductible. As a
result of this tax treatment, which stock dividends do not offer, bonds may result in
lower cost of capital than equity financing.
To illustrate the third advantage, on earnings per share, assume that
Microsystems, Inc. is considering two plans for financing the construction of a new
$5 million plant. Plan A involves issuance of 200,000 shares of common stock at the
current market price of $25 per share. Plan B involves issuance of $5 million, 8%
bonds at face value. Income before interest and taxes on the new plant will be $1.5
million. Income taxes are expected to be 30%. Microsystems currently has 100,000
shares of common stock outstanding. Illustration 10-9 shows the alternative effects
on earnings per share.
Illustration 10-9
Effects on earnings per
share—stocks vs. bonds
Income before interest and taxes
Interest (8% $5,000,000)
HELPFUL HINT
Besides corporations,
governmental agencies
and universities also
issue bonds to raise
capital.
Income before income taxes
Income tax expense (30%)
Net income
Outstanding shares
Earnings per share
Plan A
Issue Stock
Plan B
Issue Bonds
$1,500,000
—
$1,500,000
400,000
1,500,000
450,000
1,100,000
330,000
$1,050,000
$ 770,000
300,000
$3.50
100,000
$7.70
Note that net income is $280,000 less ($1,050,000 $770,000) with long-term debt
financing (bonds). However, earnings per share is higher because there are 200,000
fewer shares of common stock outstanding.
One disadvantage in using bonds is that the company must pay interest on a
periodic basis. In addition, the company must also repay the principal at the due
date. A company with fluctuating earnings and a relatively weak cash position may
have great difficulty making interest payments when earnings are low.
A corporation may also obtain long-term financing from notes payable and
leasing. However, notes payable and leasing are seldom sufficient to furnish the
amount of funds needed for plant expansion and major projects like new buildings.
Bonds are sold in relatively small denominations (usually $1,000 multiples). As
a result of their size, and the variety of their features, bonds attract many investors.
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455
Bond Basics
Types of Bonds
Bonds may have many different features. In the following sections, we describe the
types of bonds commonly issued.
SECURED AND UNSECURED BONDS
Secured bonds have specific assets of the issuer pledged as collateral for the bonds.
A bond secured by real estate, for example, is called a mortgage bond. A bond
secured by specific assets set aside to retire the bonds is called a sinking fund bond.
Unsecured bonds, also called debenture bonds, are issued against the general
credit of the borrower. Companies with good credit ratings use these bonds extensively. For example, in a recent annual report, DuPont reported over $2 billion of
debenture bonds outstanding.
Secured Bonds
No
Asset as
Collateral
Unsecured Bonds
TERM AND SERIAL BONDS
Bonds that mature—are due for payment—at a single specified future date are
term bonds. In contrast, bonds that mature in installments are serial bonds.
REGISTERED AND BEARER BONDS
Bonds issued in the name of the owner are registered bonds. Interest payments on
registered bonds are made by check to bondholders of record. Bonds not registered are bearer (or coupon) bonds. Holders of bearer bonds must send in coupons
to receive interest payments. Most bonds issued today are registered bonds.
CONVERTIBLE AND CALLABLE BONDS
Bonds that can be converted into common stock at the bondholder’s option are
convertible bonds. The conversion feature generally is attractive to bond buyers.
Bonds that the issuing company can retire at a stated dollar amount prior to maturity are callable bonds.A call feature is included in nearly all corporate bond issues.
Issuing Procedures
Bond
Convert
Stock
Convertible Bonds
“Hey Harv,
Call in those
bonds”
Bond
Bond
State laws grant corporations the power to issue bonds. Both the board of directors
and stockholders usually must approve bond issues. In authorizing the bond issue,
Bond
the board of directors must stipulate the number of bonds to be authorized, total
face value, and contractual interest rate. The total bond authorization often exCallable Bonds
ceeds the number of bonds the company originally issues. This gives the corporation the flexibility to issue more bonds, if needed, to meet future cash requirements.
The face value is the amount of principal the issuing company must pay at the
maturity date. The contractual interest rate, often referred to as the stated rate, is
the rate used to determine the amount of cash interest the borrower pays and the
investor receives. Usually the contractual rate is stated as an annual rate. Interest is
generally paid semiannually.
The terms of the bond issue are set forth in a legal document called a bond
indenture. The indenture shows the terms and summarizes the rights of the
bondholders and their trustees, and the obligations of the issuing company. The
trustee (usually a financial institution) keeps records of each bondholder, maintains custody of unissued bonds, and holds conditional title
ETHICS NOTE
to pledged property.
Some companies try to
In addition, the issuing company arranges for the printing of bond minimize the amount of debt
certificates. The indenture and the certificate are separate documents. As reported on their balance sheet
shown in Illustration 10-10 (page 456), a bond certificate provides the fol- by not reporting certain types of
lowing information: name of the issuer, face value, contractual interest commitments as liabilities. This
rate, and maturity date. An investment company that specializes in selling subject is of intense interest in
the financial community.
securities generally sells the bonds for the issuing company.
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Chapter 10 Liabilities
Issuer of
bonds
Maturity
date
Face or par
value
Contractual
interest rate
Illustration 10-10
Bond certificate
Bond Trading
Bondholders have the opportunity to convert their holdings into cash at any time
by selling the bonds at the current market price on national securities exchanges.
Bond prices are quoted as a percentage of the face value of the bond, which is
usually $1,000. A $1,000 bond with a quoted price of 97 means that the selling price
of the bond is 97% of face value, or $970. Newspapers and the financial press publish
bond prices and trading activity daily as illustrated by the following.
Illustration 10-11
Market information for
bonds
Bonds
Maturity
Close
Yield
Est. Volume
(000)
Boeing Co. 5.125
Feb. 15, 2014
96.595
5.747
33,965
This bond listing indicates that Boeing Co. has outstanding 5.125%, $1,000 bonds
that mature in 2014. They currently yield a 5.747% return. On this day, $33,965,000
of these bonds were traded. At the close of trading, the price was 96.595% of face
value, or $965.95.
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Bond Basics
A corporation makes journal entries only when it issues or buys back bonds, or
when bondholders convert bonds into common stock. For example, DuPont does
not journalize transactions between its bondholders and other investors. If Tom
Smith sells his DuPont bonds to Faith Jones, DuPont does not journalize the transaction. (DuPont or its trustee does, however, keep records of the names of bondholders in the case of registered bonds.)
Determining the Market Value of Bonds
If you were an investor wanting to purchase a bond, how would you determine how
much to pay? To be more specific, assume that Coronet, Inc. issues a zero-interest
bond (pays no interest) with a face value of $1,000,000 due in 20 years. For this
bond, the only cash you receive is a million dollars at the end of 20 years. Would
you pay a million dollars for this bond? We hope not! A million dollars received
20 years from now is not the same as a million dollars received today.
The reason you should not pay a million dollars for Coronet’s bond relates to
what is called the time value of money. If you had a million dollars today, you would
invest it. From that investment, you would earn interest such that at the end of
20 years, you would have much more than a million dollars. If someone is going to
pay you a million dollars 20 years from now, you would want to find its equivalent
today. In other words, you would want to determine how much you must invest today
at current interest rates to have a million dollars in 20 years.The amount that must be
invested today at a given rate of interest over a specified time is called present value.
The present value of a bond is the value at which it should sell in the marketplace. Market value therefore is a function of the three factors that determine
present value: (1) the dollar amounts to be received, (2) the length of time until
the amounts are received, and (3) the market rate of interest. The market interest
rate is the rate investors demand for loaning funds. Appendix 10A discusses the
process of finding the present value for bonds. Appendix C (near the end of the
book) also provides additional material for time value of money computations.
ACCOUNTING ACROSS THE ORGANIZATION
When to Go Long-Term
A decision that all companies must make is to what extent to rely on short-term
versus long-term financing. The critical nature of this decision was highlighted in
the fall of 2001, after the World Trade Center disaster. Prior to September 11, short-term interest rates had been extremely low relative to long-term rates. In order to minimize interest
costs, many companies were relying very heavily on short-term financing to purchase things
they normally would have used long-term debt for. The problem with short-term financing is
that it requires companies to continually find new financing as each loan comes due. This
makes them vulnerable to sudden changes in the economy.
After September 11, lenders and short-term investors became very reluctant to loan
money. This put the squeeze on many companies: As short-term loans came due, they were
unable to refinance. Some were able to get other financing, but at extremely high rates (for
example, 12% as compared to 3%). Others were unable to get loans and instead had to sell
assets to generate cash for their immediate needs.
Source: Henny Sender, “Firms Feel Consequences of Short-Term Borrowing,”Wall Street Journal Online, October 12, 2001.
Based on this story, what is a good general rule to use in choosing between short-term
and long-term financing?
457
HELPFUL HINT
(1) What is the price of a
$1,000 bond trading
at 951⁄4?
(2) What is the price of a
$1,000 bond trading
at 1017⁄8?
Answers: (1) $952.50.
(2) $1,018.75.
2011
$1 m
illion
≠
2031
$1 m
illion
Same dollars at different
times are not equal.
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before you go on...
Do it!
Bond Terminology
State whether each of the following statements is true or false.
_____ 1. Mortgage bonds and sinking fund bonds are both examples of secured bonds.
_____ 2. Unsecured bonds are also known as debenture bonds.
_____ 3. The stated rate is the rate investors demand for loaning funds.
_____ 4. The face value is the amount of principal the issuing company must pay at the maturity
date.
Action Plan
• Review the types of bonds and
the basic terms associated with
bonds.
_____ 5. The bond issuer must make journal entries to record transfers of its bonds among
investors.
Solution
1. True.
2. True.
3. False. The stated rate is the contractual interest rate used to determine the amount of cash
interest the borrower pays.
4. True.
5. False. The bond issuer makes journal entries only when it issues or buys back bonds, when it
records interest, and when bonds are converted.
Related exercise material: BE10-7, E10-8, E10-9, and Do it! 10-2.
✓
The Navigator
ACCOUNTING FOR BOND ISSUES
STUDY OBJECTIVE 5
Prepare the entries for the
issuance of bonds and interest
expense.
Bonds may be issued at face value, below face value (at a discount), or
above face value (at a premium).
Issuing Bonds at Face Value
To illustrate the accounting for bonds, assume that on January 1, 2011, Candlestick
Corporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). The
entry to record the sale is:
A
L
SE
100,000
Jan. 1
100,000
Cash Flows
100,000
A
L
SE
5,000 Exp
5,000
Cash Flows
5,000
Cash
Bonds Payable
(To record sale of bonds at face value)
100,000
100,000
Candlestick reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is more than one year away.
Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on
notes payable, as explained on page 447. Assume that interest is payable semiannually on January 1 and July 1 on the bonds described above. In that case, Candlestick
must pay interest of $5,000 ($100,000 10% 6/12) on July 1, 2011. The entry for
the payment, assuming no previous accrual of interest, is:
July 1
Bond Interest Expense
Cash
(To record payment of bond interest)
5,000
5,000
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Accounting for Bond Issues
At December 31, Candlestick recognizes the $5,000 of interest expense incurred
since July 1 with the following adjusting entry:
Dec. 31
Bond Interest Expense
Bond Interest Payable
(To accrue bond interest)
A
L
SE
5,000 Exp
5,000
5,000
5,000
Cash Flows
no effect
Companies classify bond interest payable as a current liability, because it is
scheduled for payment within the next year. When Candlestick pays the interest on
January 1, 2012, it debits (decreases) Bond Interest Payable and credits (decreases)
Cash for $5,000.
Discount or Premium on Bonds
Bond
Contractual
Interest
Rate 10%
Issued when
Market
Interest Rate
Bonds Sell
at
8%
Premium
10%
Face Value
12%
Discount
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. Thus, the sale of
bonds at a discount does not mean that the issuer’s financial strength is suspect.
Nor does the sale of bonds at a premium indicate exceptional financial strength.
HELPFUL HINT
Discount on
Bonds Payable
Increase
Debit
Decrease
Credit
←
In the Candlestick illustrations above, we assumed that the contractual (stated)
interest rate paid on the bonds and the market (effective) interest rate were the
same. Recall that the contractual interest rate is the rate applied to the face (par)
value to arrive at the interest paid in a year. The market interest rate is the rate investors demand for loaning funds to the corporation.When the contractual interest
rate and the market interest rate are the same, bonds sell at face value.
However, market interest rates change daily. The type of bond issued, the state
of the economy, current industry conditions, and the company’s performance all
affect market interest rates. Contractual and market interest rates often differ. As
a result, bonds often sell below or above face value.
To illustrate, suppose that a company issues 10% bonds at a time when other
bonds of similar risk are paying 12%. Investors will not be interested in buying the
10% bonds, so their value will fall below their face value. In this case, we say the
10% bonds are selling at a discount. As a result of the decline in the bonds’ selling
price, the actual interest rate incurred by the company increases to the level of the
current market interest rate.
Conversely, if the market rate of interest is lower than the contractual interest
rate, investors will have to pay more than face value for the bonds. That is, if the
market rate of interest is 8% but the contractual interest rate on the bonds is 10%,
the issuer will require more funds from the investor. In these cases, bonds sell at a
premium. Illustration 10-12 shows these relationships graphically.
Normal
Balance
Illustration 10-12
Interest rates and bond
prices
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Issuing Bonds at a Discount
To illustrate issuance of bonds at a discount, assume that on January 1, 2011,
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:
A
L
SE
92,639
Jan. 1
7,361
100,000
Cash Flows
92,639
Cash
Discount on Bonds Payable
Bonds Payable
(To record sale of bonds at a discount)
92,639
7,361
100,000
Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather,
it is a contra account. This account is deducted from bonds payable on the balance
sheet, as shown in Illustration 10-13.
Illustration 10-13
Statement presentation of
discount on bonds payable
CANDLESTICK, INC.
Balance Sheet (partial)
Long-term liabilities
Bonds payable
Less: Discount on bonds payable
HELPFUL HINT
Carrying value (book
value) of bonds issued at
a discount is determined
by subtracting the balance
of the discount account
from the balance of the
Bonds Payable account.
Illustration 10-14
Total cost of borrowing—
bonds issued at a discount
$100,000
7,361
$92,639
The $92,639 represents the carrying (or book) value of the bonds. On the date of
issue this amount equals the market price of the bonds.
The issuance of bonds below face value—at a discount—causes the total cost of
borrowing to differ from the bond interest paid. That is, the issuing corporation
must pay not only the contractual interest rate over the term of the bonds, but also
the face value (rather than the issuance price) at maturity.Therefore, the difference
between the issuance price and face value of the bonds—the discount—is an
additional cost of borrowing. The company records this additional cost as bond
interest expense over the life of the bonds.Appendices 10B and 10C show the procedures for recording this additional cost.
The total cost of borrowing $92,639 for Candlestick, Inc. is $57,361, computed
as follows.
Bonds Issued at a Discount
Semiannual interest payments
($100,000 10% 1⁄2 $5,000; $5,000 10)
Add: Bond discount ($100,000 $92,639)
Total cost of borrowing
$50,000
7,361
$57,361
Alternatively, we can compute the total cost of borrowing as follows.
Illustration 10-15
Alternative computation of
total cost of borrowing—
bonds issued at a discount
Bond Issued at a Discount
Principal at maturity
Semiannual interest payments ($5,000 10)
Cash to be paid to bondholders
Cash received from bondholders
Total cost of borrowing
$100,000
50,000
150,000
92,639
$ 57,361
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Accounting for Bond Issues
461
Issuing Bonds at a Premium
To illustrate the issuance of bonds at a premium, we now assume the Candlestick,
Inc. bonds described above sell for $108,111 (108.111% of face value) rather than
for $92,639. The entry to record the sale is:
A
Jan. 1
Cash
Bonds Payable
Premium on Bonds Payable
(To record sale of bonds at a premium)
L
SE
108,111
108,111
100,000
8,111
100,000
8,111
Cash Flows
108,111
Candlestick adds the premium on bonds payable to the bonds payable amount on
the balance sheet, as shown in Illustration 10-16 below.
Illustration 10-16
Statement presentation of
bond premium
Balance Sheet (partial)
Long-term liabilities
Bonds payable
Add: Premium on bonds payable
$100,000
8,111
$108,111
The sale of bonds above face value causes the total cost of borrowing to be less
than the bond interest paid. The bond premium is considered to be a reduction in
the cost of borrowing. The company credits the bond premium to Bond Interest
Expense over the life of the bonds. Appendices 10B and 10C show the procedures
for recording this reduction in the cost of borrowing. The total cost of borrowing
$108,111 for Candlestick, Inc. is computed as follows.
HELPFUL HINT
Premium on
Bonds Payable
Decrease
Debit
Increase
Credit
←
CANDLESTICK, INC.
Normal
Balance
Illustration 10-17
Total cost of borrowing—
bonds issued at a premium
Bonds Issued at a Premium
Semiannual interest payments
($100,000 10% 1⁄2 $5,000; $5,000 10)
Less: Bond premium ($108,111 $100,000)
$50,000
8,111
Total cost of borrowing
$41,889
Alternatively, we can compute the cost of borrowing as follows.
Bonds Issued at a Premium
Principal at maturity
Semiannual interest payments ($5,000 10)
Cash to be paid to bondholders
Cash received from bondholders
Total cost of borrowing
$100,000
50,000
Illustration 10-18
Alternative computation of
total cost of borrowing—
bonds issued at a premium
150,000
108,111
$ 41,889
before you go on...
Do it!
Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on
the balance sheet at the date of issuance.
Bond Issuance
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Action Plan
• Record cash received, bonds
payable at face value, and the
difference as a discount or
premium.
• Report discount as a deduction
from bonds payable and
premium as an addition to
bonds payable.
Solution
(a)
Cash
Discount on Bonds Payable
Bonds Payable
(To record sale of bonds at a discount)
189,000
11,000
200,000
(b)
Long-term liabilities
Bonds payable
Less: Discount on bonds payable
$200,000
11,000
$189,000
Related exercise material: BE10-8, BE10-9, BE10-10, E10-10, E10-11, E10-12, and Do it! 10-2.
✓
The Navigator
ACCOUNTING FOR BOND RETIREMENTS
STUDY OBJECTIVE 6
Describe the entries when bonds
are redeemed or converted.
An issuing corporation retires bonds either when it redeems the bonds
or when bondholders convert them into common stock. We explain the
entries for these transactions in the following sections.
Redeeming Bonds at Maturity
A
L
Regardless of the issue price of bonds, the book value of the bonds at maturity will
equal their face value. 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:
SE
100,000
Bonds Payable
Cash
(To record redemption of bonds at maturity)
100,000
Cash Flows
100,000
100,000
100,000
Redeeming Bonds before Maturity
HELPFUL HINT
A bond is redeemed
prior to its maturity
date. Its carrying value
exceeds its redemption
price. Will the retirement
result in a gain or a
loss on redemption?
Answer: Gain.
A
L
SE
100,000
1,623
1,377 Exp
103,000
Cash Flows
103,000
Bonds also may be redeemed before maturity. A company may decide to retire
bonds before maturity to reduce interest cost and to remove debt from its balance
sheet. A company should retire debt early only if it has sufficient cash resources.
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.
To illustrate, assume that 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. Assume also that 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, 2015):
Jan. 1
Bonds Payable
Premium on Bonds Payable
Loss on Bond Redemption
Cash
(To record redemption of bonds at 103)
100,000
1,623
1,377
103,000
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463
Note that the loss of $1,377 is the difference between the cash paid of $103,000 and
the carrying value of the bonds of $101,623.
Converting Bonds into Common Stock
Convertible bonds have features that are attractive both to bondholders and to the
issuer. The conversion often gives bondholders an opportunity to benefit if the
market price of the common stock increases substantially. Until conversion, though,
the bondholder receives interest on the bond. For the issuer of convertible bonds,
the bonds sell at a higher price and pay a lower rate of interest than comparable debt
securities without the conversion option. Many corporations, such as USAir, USX
Corp., and Chrysler Corporation, have convertible bonds outstanding.
When the issuing company records a conversion, the company ignores the
current market prices of the bonds and stock. Instead, the company transfers the
carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized.
To illustrate, 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:
A
July 1
Bonds Payable
Common Stock
Paid-in Capital in Excess of Par Value
(To record bond conversion)
100,000
20,000
80,000
L
SE
100,000
20,000 CS
80,000 CS
Cash Flows
no effect
Note that the company does not consider the current market price of the bonds
and stock ($130,000) in making the entry. This method of recording the bond conversion is often referred to as the carrying (or book) value method.
before you go on...
Do it!
R & B Inc. issued $500,000, 10-year bonds at a premium. Prior to maturity,
when the carrying value of the bonds is $508,000, the company retires the bonds at 102. Prepare
the entry to record the redemption of the bonds.
Solution
There is a loss on redemption: The cash paid, $510,000 ($500,000 102%), is greater than the
carrying value of $508,000. The entry is:
Bonds Payable
Premium on Bonds Payable
Loss on Bond Redemption
Cash
(To record redemption of bonds at 102)
Related exercise material: BE10-11, E10-13, E10-14, and Do it! 10-3.
500,000
8,000
2,000
Bond Redemption
Action Plan
• Determine and eliminate the
carrying value of the bonds.
• Record the cash paid.
• Compute and record the gain or
loss (the difference between
the first two items).
510,000
✓
The Navigator
ACCOUNTING FOR LONG-TERM NOTES PAYABLE
The use of notes payable in long-term debt financing is quite common.
Long-term notes payable are similar to short-term interest-bearing notes
payable except that the term of the notes exceeds one year.
STUDY OBJECTIVE 7
Describe the accounting for
long-term notes payable.
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Chapter 10 Liabilities
A long-term note may be secured by a mortgage that pledges title to specific
assets as security for a loan. Individuals widely use mortgage notes payable to purchase homes, and many small and some large companies use them to acquire plant
assets. At one time, approximately 18% of McDonald’s long-term debt related to
mortgage notes on land, buildings, and improvements.
Mortgage loan terms may stipulate either a fixed or an adjustable interest rate.
The interest rate on a fixed-rate mortgage remains the same over the life of the
mortgage. The interest rate on an adjustable-rate mortgage is adjusted periodically
to reflect changes in the market rate of interest. 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. The interest decreases each period, while the portion applied to the loan
principal increases.
Companies initially record mortgage notes payable at face value. They subsequently make entries for each installment payment. To illustrate, assume
that Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on
December 31, 2011, to obtain needed financing for a new research laboratory. 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.
Illustration 10-19
Mortgage installment
payment schedule
Semiannual
Interest
Period
(A)
Cash
Payment
(B)
Interest
Expense
(D) ⴛ 6%
(C)
Reduction
of Principal
(A) ⴚ (B)
(D)
Principal
Balance
(D) ⴚ (C)
12/31/11
06/30/12
12/31/12
06/30/13
12/31/13
$33,231
33,231
33,231
33,231
$30,000
29,806
29,601
29,383
$3,231
3,425
3,630
3,848
$500,000
496,769
493,344
489,714
485,866
Porter records the mortgage loan and first installment payment as follows.
A
L
SE
500,000
Dec. 31
500,000
Cash Flows
500,000
June 30
A
L
SE
30,000 Exp
3,231
33,231
Cash
Mortgage Notes Payable
(To record mortgage loan)
Interest Expense
Mortgage Notes Payable
Cash
(To record semiannual payment on
mortgage)
500,000
500,000
30,000
3,231
33,231
Cash Flows
33,231
In the balance sheet, the company reports the reduction in principal for the next
year as a current liability, and it classifies the remaining unpaid principal balance as
a long-term liability. At December 31, 2012, the total liability is $493,344. Of that
amount, $7,478 ($3,630 $3,848) is current, and $485,866 ($493,344 $7,478) is
long-term.
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Statement Presentation and Analysis
465
before you go on...
Do it!
Cole Research issues a $250,000, 8%, 20-year mortgage note to obtain needed
financing for a new lab. The terms call for semiannual payments of $12,631 each. Prepare the
entries to record the mortgage loan and the first installment payment.
Solution
Cash
Mortgage Notes Payable
(To record mortgage loan)
Interest Expense
Mortgage Notes Payable
Cash
(To record semiannual payment on mortgage)
250,000
250,000
10,000*
2,361
Long-Term Note
Action Plan
• Record the issuance of the note
as a cash receipt and a liability.
• Record each installment
payment that consists of
interest and payment of
principal.
12,361
*Interest expense $250,000 8% 6/12.
Related exercise material: BE10-12, E10-15, and Do it! 10-4.
✓
The Navigator
ACCOUNTING ACROSS THE ORGANIZATION
Search for Your Best Rate
Companies spend a great deal of time shopping for the best loan terms. You
should do the same. Suppose that you have a used car that you are planning
to trade in on the purchase of a new car. Experts suggest that you view this deal as three
separate transactions: (1) the purchase of a new car, (2) the trade in or sale of an old car, and
(3) shopping for an interest rate.
Studies suggest that too many people neglect transaction number 3. One survey found
that 63% of people planned on shopping for the best car-loan interest rate online the next
time they bought a car. But a separate study found that only 15% of people who bought a car
actually shopped around for the best online rate. Too many people simply take the interest
rate offered at the car dealership. Many lenders will pre-approve you for a loan up to a
specific dollar amount, and many will then give you a blank check (negotiable for up to that
amount) that you can take to the car dealer.
Source: Ron Lieber, “How to Haggle the Best Car Loan,”Wall Street Journal, March 25, 2006, p. B1.
What should you do if the dealer “trash-talks” your lender, or refuses to sell you the car
for the agreed-upon price unless you get your car loan through the dealer?
STATEMENT PRESENTATION AND ANALYSIS
Presentation
Companies report long-term liabilities in a separate section of the balance
sheet immediately following current liabilities, as shown in Illustration 10-20
on the next page.Alternatively, companies may present summary data in the
STUDY OBJECTIVE 8
Identify the methods for the
presentation and analysis of
long-term liabilities.
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balance sheet, with detailed data (interest rates, maturity dates, conversion privileges,
and assets pledged as collateral) shown in a supporting schedule. Companies report
the current maturities of long-term debt under current liabilities if they are to be paid
from current assets.
Illustration 10-20
Balance sheet presentation
of long-term liabilities
LAX CORPORATION
Balance Sheet (partial)
Long-term liabilities
Bonds payable 10% due in 2018
Less: Discount on bonds payable
Mortgage notes payable, 11%, due
in 2024 and secured by plant assets
Lease liability
$1,000,000
80,000
$ 920,000
500,000
440,000
Total long-term liabilities
$1,860,000
Analysis
Long-term creditors and stockholders are interested in a company’s long-run solvency. Of particular interest is the company’s ability to pay interest as it comes due
and to repay the face value of the debt at maturity. Debt to total assets and times
interest earned are two ratios that provide information about debt-paying ability
and long-run solvency.
The debt to total assets ratio measures the percentage of the total assets provided by creditors. As shown in the formula in Illustration 10-21, it is computed by
dividing total debt (both current and long-term liabilities) by 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.
The times interest earned ratio indicates the company’s ability to meet interest
payments as they come due. It is computed by dividing income before income taxes
and interest expense by interest expense.
To illustrate these ratios, we will use data from Kellogg Company’s recent
annual report. The company had total liabilities of $8,871 million, total assets of
$11,397 million, interest expense of $319 million, income taxes of $444 million, and
net income of $1,103 million. Kellogg’s debt to total assets ratio and times interest
earned ratio are shown below.
Illustration 10-21
Debt to total assets and
times interest earned ratios,
with computations
Total Debt
$8,871
ⴜ Total Assets ⴝ Debt to Total Assets
$11,397
77.8%
Income before
Income Taxes and ⴜ
Interest Expense
$1,103 $444 $319
Interest
Expense
ⴝ
Times Interest
Earned
$319
5.85 times
Kellogg has a relatively high debt to total assets percentage of 77.8%. Its interest coverage of 5.85 times is considered safe.
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Statement Presentation and Analysis
I N V E S T O R
I N S I G H T
”Covenant-Lite” Debt
In many corporate loans and bond issuances the lending agreement specifies debt
covenants. These covenants typically are specific financial measures, such as minimum levels
of retained earnings, cash flows, times interest earned ratios, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement; the creditors can demand immediate repayment,
or they can renegotiate the loan’s terms. Covenants protect lenders because they enable
lenders to step in and try to get their money back before the borrower gets too deep into
trouble.
During the 1990s most traditional loans specified between three to six covenants or
“triggers.” In more recent years, when lots of cash was available, lenders began reducing or
completely eliminating covenants from loan agreements in order to be more competitive with
other lenders. In a slower economy these lenders will be more likely to lose big money when
companies default.
Source: Cynthia Koons, “Risky Business: Growth of ‘Covenant-Lite’ Debt,” Wall Street Journal, June 18, 2007, p. C2.
How can financial ratios such as those covered in this chapter provide protection for
creditors?
Be sure to read
all about Y
*U
Your Boss Wants to
Know If You Ran Today
on page 468 for information on how topics in
this chapter apply to you.
467
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all about Y
Page 468
*U
Your Boss Wants to Know If You Ran Today
A
As you saw in this chapter, compensation packages
often include fringe benefits in addition to basic
salary. Health insurance is one benefit that many
employers offer. In recent years, as the cost of health
insurance has sky-rocketed, many employers either
have shifted some of the cost of health insurance
onto employees, or have discontinued health
insurance coverage altogether.
In addition, some employees are encouraging and
setting up preventive healthcare programs. Here are
the percentages for five unhealthy behaviors for
individuals with some college education: current
cigarette smoker (22.9%), five or more alcoholic
drinks at one sitting during at least once in the
past year (30%), physically inactive (30%), obese
(25.2%), or sleep less than 6 hours per day (30.3%).
Some Facts
*
*
For employers, the average cost of healthcare benefits per
employee is about $6,700 per year.
*About the Numbers
As the graph below shows, private health insurance, such as that provided by
employers, pays for less than half of healthcare costs in the U.S. If employers
continue to cut their healthcare benefits, more of the burden will shift to the
government or to individuals as out-of-pocket costs.
The Nation's Healthcare Dollar:
Where It Comes From*
Other
private
4.2%
Other government
programs
7.3%
Out-of-pocket
payments
14.3%
Medicaid
16.2%
* The rate of increase of employer healthcare costs has slowed
somewhat as employers raised the employee share of premiums
and raised deductibles (the amount of a bill that the employee
pays before insurance coverage begins).
* In 2008, it is estimated that the percentage of persons that did
not have health insurance was 14.5% (43.3 million) for persons
of all ages. Approximately 19.4% of persons under 65 years of
age were covered by public health plans, and 65.5% were
covered by private insurance.
* Government is expected to become the largest source of funding
for health care by 2016 and is projected to pay more than half of
all national health spending by 2018.
* As a percentage of payroll, the employer cost of health benefits
has exploded over the past few decades. In addition, employer
health costs for manufacturing firms in the U.S., $2.38 per worker
per hour, were much higher than the foreign trade-weighted
average of $0.96 per worker per hour in 2005. Employer health
costs make the U.S. less competitive than it could otherwise be.
* The costs and performance of America’s healthcare system are
putting workers and companies at a “significant disadvantage”
in the global marketplace. The Business Roundtable, whose
member companies provide healthcare plans for more than 35
million Americans, finds that compared with people in Canada,
Japan, Germany, the United Kingdom, and France, Americans
receive 23% less value from their healthcare system. When
compared with emerging competitors like Brazil, India, and
China, the U.S. receives 46% less value. This study finds that
for every $1 the U.S. spends on health care, its five leading
competitors spend $0.63, and the emerging competitors just
$0.15. The study also notes that “on the whole, our workforce is
not as healthy” as that of either group of competitors.
Private health
insurance
36.2%
Medicare
21.8%
* Does not add to 100% due to rounding.
Source: Data for 2007, from Centers for Medicare and Medicaid Services, Office of the Actuary,
National Health Statistics Group.
*What Do You Think?
Suppose you own a business. About a quarter of your employees smoke,
and an even higher percentage are overweight. You decide to implement a
mandatory health program that requires employees to quit smoking and to
exercise regularly, with regular monitoring. If employees do not participate in
the program, they will have to pay their own insurance premiums. Is this fair?
YES: It is the responsibility of management to try to maximize a company’s
profit. Employees with unhealthy habits drive up the cost of health insurance
because they require more frequent and more costly medical attention.
NO: What people do on their own time is their own business. This
represents an invasion of privacy, and is a form of discrimination.
Sources: Dee Gill, “Get Healthy . . . Or Else,” Inc. Magazine, April 2006; “Health Insurance Cost,” The
National Coalition on Health Care, www.nchc.org/facts/cost.shtml (accessed May 2006); Henry J. Reske,
“Hot Docs: Healthcare Costs Put U.S. Workers and Companies at Global Disadvantage,” U.S. News &
World Report, posted March 13, 2009.
*
468
The authors’ comments on this situation appear on page 504.
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Comprehensive Do it!
469
Comprehensive Do it!
Snyder Software Inc. has successfully developed a new spreadsheet program. To produce and
market the program, the company needed $2 million of additional financing. On January 1, 2012,
Snyder borrowed money as follows.
1. Snyder issued $500,000, 11%, 10-year convertible bonds. The bonds sold at face value and pay
semiannual interest on January 1 and July 1. Each $1,000 bond is convertible into 30 shares of
Snyder’s $20 par value common stock.
2. Snyder issued $1 million, 10%, 10-year bonds at face value. Interest is payable semiannually
on January 1 and July 1.
3. Snyder also issued a $500,000, 12%, 15-year mortgage note payable. The terms provide for
semiannual installment payments of $36,324 on June 30 and December 31.
Instructions
1. For the convertible bonds, prepare journal entries for:
(a) The issuance of the bonds on January 1, 2012.
(b) Interest expense on July 1 and December 31, 2012.
(c) The payment of interest on January 1, 2013.
(d) The conversion of all bonds into common stock on January 1, 2013, when the market
value of the common stock was $67 per share.
2. For the 10-year, 10% bonds:
(a) Journalize the issuance of the bonds on January 1, 2012.
(b) Prepare the journal entries for interest expense in 2012. Assume no accrual of interest on
July 1.
(c) Prepare the entry for the redemption of the bonds at 101 on January 1, 2015, after paying
the interest due on this date.
3. For the mortgage note payable:
(a) Prepare the entry for the issuance of the note on January 1, 2012.
(b) Prepare a payment schedule for the first four installment payments.
(c) Indicate the current and noncurrent amounts for the mortgage note payable at
December 31, 2012.
Solution to Comprehensive
1. (a) 2012
Jan. 1
(b) 2012
July 1
Dec. 31
(c) 2013
Jan. 1
Do it!
Cash
Bonds Payable
(To record issue of 11%, 10-year
convertible bonds at face value)
500,000
500,000
Bond Interest Expense
Cash ($500,000 0.055)
(To record payment of semiannual
interest)
27,500
Bond Interest Expense
Bond Interest Payable
(To record accrual of semiannual
interest)
27,500
Bond Interest Payable
Cash
(To record payment of accrued
interest)
27,500
27,500
27,500
27,500
Action plan
• Compute interest semiannually
(six months).
• Record the accrual and payment
of interest on appropriate dates.
• Record the conversion of the
bonds into common stock by
removing the book (carrying)
value of the bonds from the
liability account.
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Chapter 10 Liabilities
(d) Jan. 1
Action Plan
• Record the issuance of the
bonds.
• Compute interest expense for
each period.
• Compute the loss on bond
redemption as the excess of the
cash paid over the carrying
value of the redeemed bonds.
2. (a) 2012
Jan. 1
(b) 2012
July 1
Dec. 31
(c) 2015
Jan. 1
Action Plan
• Compute periodic interest
expense on a mortgage note,
recognizing that as the principal
amount decreases, so does the
interest expense.
• Record mortgage payments,
recognizing that each payment
consists of (1) interest on the
unpaid loan balance and (2) a
reduction of the loan principal.
3. (a) 2012
Jan. 1
Bonds Payable
Common Stock
Paid-in Capital in Excess of Par Value
(To record conversion of bonds into
common stock)
*($500,000 $1,000 500 bonds;
500 30 15,000 shares;
15,000 $20 $300,000)
Cash
Bonds Payable
(To record issuance of bonds)
500,000
300,000*
200,000
1,000,000
1,000,000
Bond Interest Expense
Cash
(To record payment of semiannual
interest)
50,000
Bond Interest Expense
Bond Interest Payable
(To record accrual of semiannual
interest)
50,000
Bond Payable
Loss on Bond Redemption
Cash
(To record redemption of bonds
at 101)
*($1,010,000 $1,000,000)
Cash
Mortgage Notes Payable
(To record issuance of mortgage note
payable)
50,000
50,000
1,000,000
10,000*
1,010,000
500,000
500,000
(b) Semiannual
Interest
Period
(A)
Cash
Payment
(B)
Interest
Expense
(C)
Reduction
of Principal
(D)
Principal
Balance
Issue date
1
2
3
4
$36,324
36,324
36,324
36,324
$30,000
29,621
29,218
28,792
$6,324
6,703
7,106
7,532
$500,000
493,676
486,973
479,867
472,335
(c) Current liability
Long-term liability
$14,638 ($7,106 $7,532)
$472,335
✓
The Navigator
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Glossary
471
SUMMARY OF STUDY OBJECTIVES
1 Explain a current liability, and identify the major types
of current liabilities. A current liability is a debt that can
reasonably be expected to be paid (1) from existing current
assets or through the creation of other current liabilities,
and (2) within one year or the operating cycle, whichever is
longer. The major types of current liabilities are notes
payable, accounts payable, sales taxes payable, unearned
revenues, and accrued liabilities such as taxes, salaries and
wages, and interest payable.
2 Describe the accounting for notes payable. When a
promissory note is interest-bearing, the amount of assets
received upon the issuance of the note is generally equal to
the face value of the note. Interest expense is accrued over
the life of the note. At maturity, the amount paid is equal to
the face value of the note plus accrued interest.
3 Explain the accounting for other current liabilities.
Sales taxes payable are recorded at the time the related
sales occur.The company serves as a collection agent for the
taxing authority. Sales taxes are not an expense to the
company. Until employee withholding taxes are remitted to
governmental taxing authorities, they are credited to appropriate liability accounts. Unearned revenues are initially
recorded in an unearned revenue account.As the revenue is
earned, a transfer from unearned revenue to earned revenue
occurs. The current maturities of long-term debt should be
reported as a current liability in the balance sheet.
4 Explain why bonds are issued, and identify the types
of bonds. Bonds may be sold to many investors, and they
offer the following advantages over common stock:
(a) stockholder control is not affected, (b) tax savings
result, and (c) earnings per share of common stock may be
higher. The following different types of bonds may be
issued: secured and unsecured bonds, term and serial
bonds, registered and bearer bonds, convertible and
callable bonds.
5 Prepare the entries for the issuance of bonds and interest expense. When bonds are issued, Cash is debited
for the cash proceeds, and Bonds Payable is credited for the
face value of the bonds. The account Premium on Bonds
Payable is used to show a bond premium; Discount on
Bonds Payable is used to show a bond discount.
6 Describe the entries when bonds are redeemed or
converted. When bonds are redeemed at maturity, Cash
is credited and Bonds Payable is debited for the face value
of the bonds. When bonds are redeemed before maturity,
it is necessary to (a) eliminate the carrying value of the
bonds at the redemption date, (b) record the cash paid, and
(c) recognize the gain or loss on redemption. When bonds
are converted to common stock, the carrying (or book)
value of the bonds is transferred to appropriate paid-in
capital accounts; no gain or loss is recognized.
7 Describe the accounting for long-term notes payable.
Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. The
interest decreases each period, while the portion applied to
the loan principal increases.
8 Identify the methods for the presentation and analysis
of long-term liabilities. The nature and amount of each
long-term debt should be reported in the balance sheet or
in the notes accompanying the financial statements.
Stockholders and long-term creditors are interested in a
company’s long-run solvency. Debt to total assets and times
interest earned are two ratios that provide information
about debt-paying ability and long-run solvency.
✓
The Navigator
GLOSSARY
Bearer (coupon) bonds
Bonds not registered. (p. 455).
Bond certificate A legal document that indicates the name
of the issuer, the face value of the bonds, and such other
data as the contractual interest rate and maturity date of
the bonds. (p. 455).
Bond discount The amount by which a bond sells at less
than its face value. (p. 459).
Bond indenture A legal document that sets forth the terms
of the bond issue. (p. 455).
Bond premium The amount by which a bond sells above its
face value. (p. 459).
Bonds A form of interest-bearing notes payable issued
by corporations, universities, and governmental entities.
(p. 453).
Callable bonds Bonds that are subject to retirement at a
stated dollar amount prior to maturity at the option of the
issuer. (p. 455).
Contractual interest rate Rate used to determine the
amount of interest the borrower pays and the investor
receives. (p. 455).
Convertible bonds Bonds that permit bondholders to convert them into common stock at their option. (p. 455).
Current liabilities Debts that a company reasonably expects to pay from existing current assets within the next
year or operating cycle. (p. 446).
Current ratio A measure of a company’s liquidity; computed
as current assets divided by current liabilities. (p. 453).
Debenture bonds Bonds issued against the general credit
of the borrower. Also called unsecured bonds. (p. 455).
Debt to total assets ratio A solvency measure that indicates the percentage of total assets provided by creditors;
computed as total debt divided by total assets. (p. 466).
Face value Amount of principal the issuer must pay at the
maturity date of the bond. (p. 455).
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Long-term liabilities
one year. (p. 453).
Obligations expected to be paid after
Market interest rate The rate investors demand for loaning funds to the corporation. (p. 457).
Mortgage bond
A bond secured by real estate. (p. 455).
Mortgage note payable A long-term note secured by a
mortgage that pledges title to specific assets as security for
a loan. (p. 464).
Notes payable Obligations in the form of written promissory notes. (p. 447).
Registered bonds Bonds issued in the name of the owner.
(p. 455).
Secured bonds Bonds that have specific assets of the issuer
pledged as collateral. (p. 455).
Serial bonds Bonds that mature in installments. (p. 455).
Sinking fund bonds Bonds secured by specific assets set
aside to retire them. (p. 455).
Term bonds Bonds that mature at a single specified future
date. (p. 455).
Times interest earned ratio A solvency measure that indicates a company’s ability to meet interest payments; computed by dividing income before income taxes and interest
expense by interest expense. (p. 466).
Unsecured bonds Bonds issued against the general credit
of the borrower. Also called debenture bonds. (p. 455).
Working capital A measure of a company’s liquidity; computed as current assets minus current liabilities. (p. 452).
Present Value Concepts Related
to Bond Pricing
APPENDIX 10A
Congratulations! You have a winning lottery ticket and the state has provided you
with three possible options for payment. They are:
1. Receive $10,000,000 in three years.
2. Receive $7,000,000 immediately.
3. Receive $3,500,000 at the end of each year for three years.
Which of these options would you select? The answer is not easy to determine at a
glance. To make a dollar-maximizing choice, you must perform present value computations. A present value computation is based on the concept of time value of
money. Time value of money concepts are useful for the lottery situation and for
pricing other amounts to be received in the future. This appendix discusses how to
use present value concepts to price bonds. It also will tell you how to determine
what option you should take as a lottery winner.
Present Value of Face Value
STUDY OBJECTIVE 9
Compute the market price of a
bond.
Illustration 10A-1
Present value computation—
$1,000 discounted at 10%
for one year
To illustrate present value concepts, assume that you are willing to invest a
sum of money that will yield $1,000 at the end of one year. In other words,
what amount would you need to invest today to have $1,000 one year from
now? If you want to earn 10%, the investment (or present value) is $909.09
($1,000 1.10). Illustration 10A-1 shows the computation.
Present Value ⴛ (1 ⴙ Interest Rate)
Present value
(1 10%)
Present value
Present value
ⴝ Future Amount
$1,000
$1,000 1.10
$909.09
The future amount ($1,000), the interest rate (10%), and the number of periods
(1) are known. We can depict the variables in this situation as shown in the time
diagram in Illustration 10A-2.
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Appendix 10A
Present Value Concepts Related to Bond Pricing
Present
Value (?)
i = 10%
Future
Amount
$909.09
n = 1 year
$1,000
473
Illustration 10A-2
Finding present value if
discounted for one period
If you are to receive the single future amount of $1,000 in two years, discounted at
10%, its present value is $826.45 [($1,000 1.10) 1.10], depicted as follows.
Present
Value (?)
i = 10%
Future
Amount
0
$826.45
1
n = 2 years
2
$1,000
Illustration 10A-3
Finding present value if
discounted for two periods
We also can determine the present value of 1 through tables that show the
present value of 1 for n periods. In Table 10A-1 below, n is the number of discounting periods involved. The percentages are the periodic interest rates, and the fivedigit decimal numbers in the respective columns are the factors for the present
value of 1.
When using Table 10A-1, we multiply the future amount by the present value
factor specified at the intersection of the number of periods and the interest rate.
For example, the present value factor for 1 period at an interest rate of 10% is .90909,
which equals the $909.09 ($1,000 .90909) computed in Illustration 10A-1.
TABLE 10A-1
Present Value of 1
(n)
Periods
4%
5%
6%
8%
9%
10%
11%
12%
15%
1
2
3
4
5
.96154
.92456
.88900
.85480
.82193
.95238
.90703
.86384
.82270
.78353
.94340
.89000
.83962
.79209
.74726
.92593
.85734
.79383
.73503
.68058
.91743
.84168
.77218
.70843
.64993
.90909
.82645
.75132
.68301
.62092
.90090
.81162
.73119
.65873
.59345
.89286
.79719
.71178
.63552
.56743
.86957
.75614
.65752
.57175
.49718
6
7
8
9
10
.79031
.75992
.73069
.70259
.67556
.74622
.71068
.67684
.64461
.61391
.70496
.66506
.62741
.59190
.55839
.63017
.58349
.54027
.50025
.46319
.59627
.54703
.50187
.46043
.42241
.56447
.51316
.46651
.42410
.38554
.53464
.48166
.43393
.39092
.35218
.50663
.45235
.40388
.36061
.32197
.43233
.37594
.32690
.28426
.24719
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For two periods at an interest rate of 10%, the present value factor is .82645, which
equals the $826.45 ($1,000 .82645) computed previously.
Let’s now go back to our lottery example. Given the present value concepts
just learned, we can determine whether receiving $10,000,000 in three years is
better than receiving $7,000,000 today, assuming the appropriate discount rate is
9%. The computation is as follows.
Illustration 10A-4
Present value of $10,000,000
to be received in three years
$10,000,000 PV of 1 due in 3 years at 9%
$10,000,000 .77218 (Table 10A-1)
Amount to be received from state immediately
$7,721,800
7,000,000
Difference
$ 721,800
What this computation shows you is that you would be $721,800 better off receiving the $10,000,000 at the end of three years rather than taking $7,000,000 immediately.
Present Value of Interest Payments (Annuities)
In addition to receiving the face value of a bond at maturity, an investor also receives
periodic interest payments over the life of the bonds. These periodic payments are
called annuities.
In order to compute the present value of an annuity, we need to know: (1) the
interest rate, (2) the number of interest periods, and (3) the amount of the periodic
receipts or payments.To illustrate the computation of the present value of an annuity, assume that you will receive $1,000 cash annually for three years and the interest rate is 10%. The time diagram in Illustration 10A-5 depicts this situation.
Illustration 10A-5
Time diagram for a
three-year annuity
PV = ?
$1,000
Now
1
i = 10%
n=3
$1,000
$1,000
2
3 years
The present value in this situation may be computed as follows.
Illustration 10A-6
Present value of a series of
future amounts computation
Future Amount
$1,000 (1 year away)
1,000 (2 years away)
1,000 (3 years away)
ⴛ
Present Value of 1
Factor at 10%
ⴝ
Present Value
.90909
.82645
.75132
$ 909.09
826.45
751.32
2.48686
$2,486.86
We also can use annuity tables to value annuities. As illustrated in Table 10A-2,
these tables show the present value of 1 to be received periodically for a given
number of periods.
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Appendix 10A
Present Value Concepts Related to Bond Pricing
475
TABLE 10A-2
Present Value of an Annuity of 1
(n)
Periods
4%
5%
6%
8%
9%
10%
11%
12%
15%
1
2
3
4
5
.96154
1.88609
2.77509
3.62990
4.45182
.95238
1.85941
2.72325
3.54595
4.32948
.94340
1.83339
2.67301
3.46511
4.21236
.92593
1.78326
2.57710
3.31213
3.99271
.91743
1.75911
2.53130
3.23972
3.88965
.90909
1.73554
2.48685
3.16986
3.79079
.90090
1.71252
2.44371
3.10245
3.69590
.89286
1.69005
2.40183
3.03735
3.60478
.86957
1.62571
2.28323
2.85498
3.35216
6
7
8
9
10
5.24214
6.00205
6.73274
7.43533
8.11090
5.07569
5.78637
6.46321
7.10782
7.72173
4.91732
5.58238
6.20979
6.80169
7.36009
4.62288
5.20637
5.74664
6.24689
6.71008
4.48592
5.03295
5.53482
5.99525
6.41766
4.35526
4.86842
5.33493
5.75902
6.14457
4.23054
4.71220
5.14612
5.53705
5.88923
4.11141
4.56376
4.96764
5.32825
5.65022
3.78448
4.16042
4.48732
4.77158
5.01877
From Table 10A-2 you can see that the present value factor of an annuity of
1 for three periods at 10% is 2.48685.2 This present value factor is the total of the
three individual present value factors as shown in Illustration 10A-6. Applying this
amount to the annual cash flow of $1,000 produces a present value of $2,486.85.
Let’s now go back to our lottery example. We determined that you would get
more money if you wait and take the $10,000,000 in three years rather than take
$7,000,000 immediately. But there is still another option—to receive $3,500,000 at
the end of each year for three years (an annuity). The computation to evaluate this
option (again assuming a 9% discount rate) is as follows.
$3,500,000 PV of 1 due yearly for 3 years at 9%
$3,500,000 2.53130 (Table 10A-2)
Present value of $10,000,000 to be received in 3 years
$8,859,550
7,721,800
Difference
$1,137,750
If you take the annuity of $3,500,000 for each of three years, you will be $1,137,750
richer as a result.
Time Periods and Discounting
We have used an annual interest rate to determine present value. Present value computations may also be done over shorter periods of time, such as monthly, quarterly,
or semiannually. When the time frame is less than one year, it is necessary to convert
the annual interest rate to the shorter time frame.
Assume, for example, that the investor in Illustration 10A-6 received $500
semiannually for three years instead of $1,000 annually. In this case, the number of
periods becomes six (3 2), the interest rate is 5% (10% 2), the present value
factor from Table 10A-2 is 5.07569, and the present value of the future cash flows is
$2,537.85 (5.07569 $500). This amount is slightly higher than the $2,486.86 computed in Illustration 10A-6 because interest is computed twice during the same
year. That is, interest is earned on the first half year’s interest.
2
The difference of .00001 between 2.48686 and 2.48685 is due to rounding.
Illustration 10A-7
Present value of lottery
payments to be received
over three years
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Chapter 10 Liabilities
Computing the Present Value of a Bond
The present value (or market price) of a bond is a function of three variables: (1) the
payment amounts, (2) the length of time until the amounts are paid, and (3) the interest (discount) rate.
The first variable (dollars to be paid) is made up of two elements: (1) a series
of interest payments (an annuity), and (2) the principal amount (a single sum). To
compute the present value of the bond, we must discount both the interest payments and the principal amount.
When the investor’s interest (discount) rate is equal to the bond’s contractual
interest rate, the present value of the bonds will equal the face value of the bonds.
To illustrate, assume a bond issue of 10%, five-year bonds with a face value of
$100,000 with interest payable semiannually on January 1 and July 1. If the discount
rate is the same as the contractual rate, the bonds will sell at face value. In this case,
the investor will receive: (1) $100,000 at maturity and (2) a series of ten $5,000 interest payments [$100,000 (10% 2)] over the term of the bonds. The length of
time is expressed in terms of interest periods (in this case, 10) and the discount rate
per interest period (5%). The time diagram in Illustration 10A-8 below depicts the
variables involved in this discounting situation.
Illustration 10A-8
Time diagram for the
present value of a 10%,
five-year bond paying
interest semiannually
Diagram
for
Principal
Present
Value
(?)
Now
Diagram
for
Interest
Principal
Amount
$100,000
i = 5%
1
2
3
4
5
n = 10
6
7
8
9
10
Present
Interest
Value
i = 5%
Payments
(?)
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
Now
1
2
3
4
5
n = 10
6
7
8
9
10
The computation of the present value of Candlestick’s bonds, assuming they were
issued at face value (page 458), is shown below.
Illustration 10A-9
Present value of principal
and interest (face value)
10% Contractual Rate—10% Discount Rate
Present value of principal to be received at maturity
$100,000 PV of 1 due in 10 periods at 5%
$100,000 .61391 (Table 10A-1)
Present value of interest to be received periodically
over the term of the bonds
$5,000 PV of 1 due periodically for 10 periods at 5%
$5,000 7.72173 (Table 10A-2)
Present value of bonds
*Rounded.
$ 61,391
38,609*
$100,000
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Appendix 10B
Effective-Interest Method of Bond Amortization
477
Now assume that the investor’s required rate of return is 12%, not 10%. The
future amounts are again $100,000 and $5,000, respectively. But now we must use a
discount rate of 6% (12% 2). The present value of Candlestick’s bonds issued at
a discount (page 460) is $92,639 as computed below.
Illustration 10A-10
Present value of principal
and interest (discount)
10% Contractual Rate—12% Discount Rate
Present value of principal to be received at maturity
$100,000 .55839 (Table 10A-1)
Present value of interest to be received periodically
over the term of the bonds
$5,000 7.36009 (Table 10A-2)
$55,839
36,800
Present value of bonds
$92,639
If the discount rate is 8% and the contractual rate is 10%, the present value of
Candlestick’s bonds issued at a premium (page 461) is $108,111 as computed below.
Illustration 10A-11
Present value of principal
and interest (premium)
10% Contractual Rate—8% Discount Rate
Present value of principal to be received at maturity
$100,000 .67556 (Table 10A-1)
Present value of interest to be received periodically
over the term of the bonds
$5,000 8.11090 (Table 10A-2)
Present value of bonds
$ 67,556
40,555
$108,111
SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 10A
9 Compute the market price of a bond. Time value of
money concepts are useful for pricing bonds. The present
value (or market price) of a bond is a function of three
variables: (1) the payment amounts, (2) the length of time
until the amounts are paid, and (3) the interest rate.
Effective-Interest Method
of Bond Amortization
APPENDIX 10B
Under the effective-interest method, the amortization of bond discount
or bond premium results in periodic interest expense equal to a constant
percentage of the carrying value of the bonds. The effective-interest
method results in varying amounts of amortization and interest expense
per period but a constant percentage rate.
The following steps are required under the effective-interest method.
STUDY OBJECTIVE 10
Apply the effective-interest
method of bond discount and
bond premium.
1. Compute the bond interest expense.To do so, multiply the carrying value of the
bonds at the beginning of the interest period by the effective-interest rate.
2. Compute the bond interest paid (or accrued). To do so, multiply the face value
of the bonds by the contractual interest rate.
3. Compute the amortization amount.To do so, determine the difference between
the amounts computed in steps (1) and (2).
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Chapter 10 Liabilities
Illustration 10B-1 depicts these steps.
Illustration 10B-1
Computation of
amortization—effectiveinterest method
(1)
Bond Interest Expense
(2)
Bond Interest Paid
冢
冢
冢
冢
Carrying Value
Effectiveof Bonds
ⴛ Interest ⴚ
at Beginning
Rate
of Period
(3)
Face
Contractual
ⴝ Amortization
Amount ⴛ Interest
Amount
of Bonds
Rate
When the difference between the straight-line method of amortization
(Appendix 10C) and the effective-interest method is material, GAAP requires the
use of the effective-interest method.
Amortizing Bond Discount
To illustrate the effective-interest method of bond discount amortization, assume
that Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2011,
with interest payable each July 1 and January 1 (page 460). The bonds sell for
$92,639 (92.639% of face value). This sales price results in bond discount of $7,361
($100,000 $92,639) and an effective-interest rate of 12%. A bond discount
amortization schedule, as shown in Illustration 10B-2, facilitates the recording of
Illustration 10B-2
Bond discount amortization
schedule
Candlestick Inc.xls
File
Edit
View
Insert
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
Format
B
Tools
Data
Window
Help
C
D
E
F
(D)
Unamortized
Discount
(D) ⴚ (C)
(E)
Bond
Carrying Value
($100,000 ⴚ D)
$7,361
6,803
6,211
5,584
4,919
4,214
3,467
2,675
1,835
945
– 0–
$92,639
93,197
93,789
94,416
95,081
95,786
96,533
97,325
98,165
99,055
100,000
CANDLESTICK, INC.
Bond Discount Amortization
Effective-Interest Method—Semiannual Interest Payments
10% Bonds Issued at 12%
Semiannual
Interest
Periods
Issue date
1
2
3
4
5
6
7
8
9
10
(A)
Interest to Be Paid
(5% ⴛ $100,000)
(B)
Interest Expense
to Be Recorded
(6% ⴛ Preceding Bond
Carrying Value)
(C)
Discount
Amortization
(B) ⴚ (A)
$ 5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
$50,000
$ 5,558 (6% ⴛ $92,639)
(6% $93,197)
5,592
(6% $93,789)
5,627
(6% $94,416)
5,665
(6% $95,081)
5,705
(6% $95,786)
5,747
(6% $96,533)
5,792
(6% $97,325)
5,840
(6% $98,165)
5,890
5,945* (6% $99,055)
$57,361
$ 558
592
627
665
705
747
792
840
890
945
$7,361
Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the semiannual contractual interest rate
(5%) each period.
Column (B) is computed as the preceding bond carrying value times the semiannual effective-interest rate (6%).
Column (C) indicates the discount amortization each period.
Column (D) decreases each period until it reaches zero at maturity.
Column (E) increases each period until it equals face value at maturity.
*$2 difference due to rounding.
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Appendix 10B
Effective-Interest Method of Bond Amortization
479
interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 6%.
We have highlighted columns (A), (B), and (C) in the amortization schedule
to emphasize their importance. These three columns provide the numbers for
each period’s journal entries. They are the primary reason for preparing the
schedule.
For the first interest period, the computations of bond interest expense and the
bond discount amortization are:
Bond interest expense ($92,639 6%)
Contractual interest ($100,000 5%)
$5,558
5,000
Bond discount amortization
$ 558
Illustration 10B-3
Computation of bond
discount amortization
Candlestick records the payment of interest and amortization of bond discount
on July 1, 2011, as follows.
A
July 1
Bond Interest Expense
Discount on Bonds Payable
Cash
(To record payment of bond interest
and amortization of bond discount)
L
SE
5,558 Exp
5,558
558
5,000
558
5,000
Cash Flows
5,000
For the second interest period, bond interest expense will be $5,592 ($93,197
6%), and the discount amortization will be $592. At December 31, Candlestick
makes the following adjusting entry.
A
Dec. 31
Bond Interest Expense
Discount on Bonds Payable
Bond Interest Payable
(To record accrued bond interest
and amortization of bond discount)
L
SE
5,592 Exp
5,592
592
5,000
Total bond interest expense for 2011 is $11,150 ($5,558 $5,592). On January 1,
Candlestick records payment of the interest by a debit to Bond Interest Payable
and a credit to Cash.
Amortizing Bond Premium
The amortization of bond premium by the effective-interest method is similar
to the procedures described for bond discount. For example, assume that
Candlestick, Inc. issues $100,000, 10%, five-year bonds on January 1, 2011, with
interest payable on July 1 and January 1 (page 461). In this case, the bonds sell for
$108,111. This sales price results in bond premium of $8,111 and an effectiveinterest rate of 8%. Illustration 10B-4 on the next page shows the bond premium
amortization schedule.
592
5,000
Cash Flows
no effect
HELPFUL HINT
When a bond sells for
$108,111, it is quoted as
108.111% of face value.
Note that $108,111 can
be proven as shown in
Appendix 10A.
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Candlestick Inc.xls
File
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View
Insert
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
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Data
B
Window
Help
C
D
E
F
(D)
Unamortized
Premium
(D) ⴚ (C)
(E)
Bond
Carrying Value
($100,000 ⴙ D)
$8,111
7,435
6,732
6,001
5,241
4,451
3,629
2,774
1,885
960
–0–
$108,111
107,435
106,732
106,001
105,241
104,451
103,629
102,774
101,885
100,960
100,000
CANDLESTICK, INC.
Bond Premium Amortization
Effective-Interest Method—Semiannual Interest Payments
10% Bonds Issued at 8%
Semiannual
Interest
Periods
(A)
Interest to Be Paid
(5% ⴛ $100,000)
Issue date
1
2
3
4
5
6
7
8
9
10
$ 5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
$50,000
(B)
Interest Expense
to Be Recorded
(4% ⴛ Preceding Bond
Carrying Value)
$ 4,324
4,297
4,269
4,240
4,210
4,178
4,145
4,111
4,075
4,040 *
$41,889
(4% ⴛ $108,111)
(4% $107,435)
(4% $106,732)
(4% $106,001)
(4% $105,241)
(4% $104,451)
(4% $103,629)
(4% $102,774)
(4% $101,885)
(4% $100,960)
(C)
Premium
Amortization
(A) ⴚ (B)
$ 676
703
731
760
790
822
855
889
925
960
$8,111
Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the semiannual contractual interest rate
(5%) each period.
Column (B) is computed as the carrying value of the bonds times the semiannual effective-interest rate (4%).
Column (C) indicates the premium amortization each period.
Column (D) decreases each period until it reaches zero at maturity.
Column (E) decreases each period until it equals face value at maturity.
*$2 difference due to rounding.
Illustration 10B-4
Bond premium amortization
schedule
For the first interest period, the computations of bond interest expense and the
bond premium amortization are:
Illustration 10B-5
Computation of bond
premium amortization
A
Tools
L
SE
4,324 Exp
676
5,000
Cash Flows
5,000
Bond interest expense ($108,111 4%)
Contractual interest ($100,000 5%)
$4,324
5,000
Bond premium amortization
$ 676
Candlestick records payments on the first interest date as follows.
July 1
Bond Interest Expense
Premium on Bonds Payable
Cash
(To record payment of bond interest
and amortization of bond premium)
4,324
676
5,000
For the second interest period, interest expense will be $4,297, and the premium
amortization will be $703. Total bond interest expense for 2011 is $8,621 ($4,324
$4,297).
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Appendix 10C
Comprehensive Do it!
Straight-Line Amortization
for Appendix 10B
Gardner Corporation issues $1,750,000, 10-year, 12% bonds on January 1, 2011, at $1,820,000, to
yield 10%. The bonds pay semiannual interest July 1 and January 1. Gardner uses the effectiveinterest method of amortization.
Instructions
(a) Prepare the journal entry to record the issu...
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