Chapter 10
ACCOUNTING FOR LONG-TERM LIABILITIES
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises Problems Beyond the
Numbers
Conceptual objectives:
C1. Explain the types and payment
patterns of notes.
1 10-11 10-10, 10-11,
10-20
10-6
C2. Explain and compute the
present value of an amount to
be paid at a future date.
(Appendix 10A)
C3. Describe interest accrual when
bond payment periods differ
from accounting periods.
(Appendix 10C)
10-16 10-15, 10-16 10-7
C4. Describe the accounting for
leases and pensions.
(Appendix 10D)
18, 19, 20 10-17, 10-18 10-17 10-11 10-3
Analytical objectives:
A1. Compare bond financing with
stock financing.
2, 3, 4, 5, 6,
7, 13, 15
10-1 10-1, 10-3,
10-7, 10-8
A2. Assess debt features and their
implications.
16 10-12 10-1, 10-5
A3. Compute the debt-to-equity
ratio and explain its use.
12, 17 10-13 10-17 10-2, 10-9
P1. Prepare entries to record bond
issuance and bond interest
expense.
8, 9, 10, 11,
14
10-2, 10-3,
10-4, 10-5,
10-7, 10-19,
10-20
10-1, 10-4,
10-5, 10-6,
10-16
10-1, 10-2,
10-3, 10-4,
10-5, 10-8,
10-9, 10-10
P2. Compute and record
amortization of bond discount.
10-6, 10-7 10-2, 10-3,
10-4, 10-5,
10-9, 10-15
10-2, 10-5 10-6
P3. Compute and record
amortization of bond premium.
10-8 10-6, 10-7,
10-8
10-3, 10-4,
10-5
10-4, 10-6
P4. Record the retirement of bonds. 10-9, 10-10 10-9, 10-18,
10-19
10-10
This grid is continued on next page
10-1
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises Problems Beyond the
Numbers
P5. Compute and record
amortization of bond discount
using effective interest method.
(Appendix 10B)
10-14 10-13 10-8, 10-10
P6. Compute and record
amortization of bond premium
using effective interest method.
(Appendix 10B)
10-15 10-14 10-9, 10-10
Additional Information on Related Assignment Material
Corresponding problems in set B (in text) also relate to learning objectives identified in grid on
previous page. The Serial Problem for Success Systems continues in this chapter. Problem 10-2A,
10-4A, 10-8A, 10-10A, can be completed with Excel.
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be
used in practice, homework, or exam mode.
Stone + Cloth: NEW opener with new entrepreneurial assignment
New learning notes for bond interest computations
New color highlighting for learning amortization
New T-accounts for learning bond amortization
Updated debt-to-equity analysis using Amazon
10-2
Chapter Outline Notes
I. Basics of Bonds
Projects that demand large amounts of money often are funded from
bond issuances.
A. Bond Financing
1. A bond is its issuer’s written promise to pay an amount
identified as the par value of the bond with interest.
a. Most bonds require the issuer to make periodic interest
payments.
b. The par value of a bond, also called the face amount or
face value, is paid at a specified future date known as the
maturity date.
c. most bonds also require the issuer to make semiannual
interest payments. The amount of interest paid is computed
as par (face amount) value x contract rate of interest
2. Advantages of bonds
a. Bonds do not affect owner control.
b. Interest on bonds is tax deductible.
c. Bonds can increase return on equity. A company that earns a
higher return with borrowed funds than it pays in interest on
those funds increases its return on equity. This process is
called financial leverage or trading on the equity.
3. Disadvantages of bonds
a. Bonds can decrease return on equity. A company that earns a
lower return with borrowed funds than it pays in interest on
those funds decreases its return on equity.
b. Bonds require payment of both periodic interest and par
value at maturity. Equity financing, by contrast, does not
require any payments because cash withdrawals (dividends)
are paid at the discretion of the owner (board).
B. Bond Trading
1. Bonds can be traded on exchanges including both the New York
Stock Exchange and the American Stock Exchange.
2. A bond issue consists of a large number of bonds (denominations
of $1,000 or $5,000, etc.) that are sold to many different lenders.
3. Market value (price) is expressed as a percentage of par (face)
value. Examples: bonds issued at 103 ½ means that they are sold
for 103.5% of their par value. Bonds issued at 95 means that
they are sold for 95% of their par value.
C. Bond-Issuing Procedures
Governed by state and federal laws. Bond issuers also want to be
sure they do not violate any existing contractual agreements.
10-3
Chapter Outline Notes
1. Bond indenture is the contract between the bond issuer and the
bondholders; it identifies the obligations and rights of each party.
A bondholder may also receive a bond certificate that includes
specifics such as the issuer’s name, the par value, the contract
interest rate, and the maturity date.
2. Issuing corporation normally sells its bonds to an investment
firm (the underwriter), which resells the bonds to the public.
3. A trustee (usually a bank or trust company) monitors the issuer
to ensure it complies with the obligations in the indenture.
1. Issue date: debit Cash, credit Bonds Payable (face amount).
2. Interest date: debit Interest Expense, credit Cash (face times
bond interest rate times interest period).
3. Maturity date: debit Bonds Payable, credit Cash (face amount).
B. Bond Discount or Premium—bonds are sold for an amount different
than the face amount.
1. Contract rate—(also called coupon rate, stated rate, or
nominal rate) annual interest rate paid by the issuer of bonds
(applied to par value).
2. Market rate—annual rate borrowers are willing to pay and
lenders are willing to accept for a particular bond and its risk
level.
3. When contract rate and market rate are equal, bonds sell at par
value; when contract rate is above market rate, bonds sell at a
premium (above par); when the contract rate is below market
rate, bonds sell at a discount (below par).
C. Issuing Bonds at a Discount—sell bonds for less than par value.
1. The discount on bonds payable is the difference between the
par (face) value of a bond and its lower issuance price.
2. Entry to record issuance at a discount: debit Cash (issue price),
debit Discount on Bonds Payable (amount of discount), credit
Bonds Payable (par value).
3. Discount on Bonds Payable is a contra liability account; it is
deducted from par value to yield the carrying (book) value of
the bonds payable.
10-4
Chapter Outline Notes
4. Amortizing a Bond Discount
a. Total bond interest expense is the sum of all the cash interest
payments plus the bond discount (or can be computed by
comparing total amount borrowed to total amount repaid
over life).
b. Discount must be systematically reduced (amortized) over
the life of the bond to report periodic interest expense
incurred.
c. Requires crediting Discount on Bonds Payable when bond
interest expense is recorded (payment and/or accruals) and
increasing Interest Expense by the amortized amount.
d.Amortizing the discount increases book value; at maturity,
the unamortized discount equals zero and the carrying value
equals par value.
5. Straight-line method—allocates an equal portion of the total
discount to bond interest expense in each of the six-month
interest periods.
D. Issuing Bonds at a Premium—sell bonds for more than par value.
1. The premium on bonds payable is the difference between the
par value of a bond and its higher issuance price.
2. Entry to record issuance at a premium: debit Cash (issue price),
credit Premium on Bonds Payable (amount of premium), credit
Bonds Payable (par value).
3. Premium on Bonds Payable is an adjunct liability account; it is
added to par value to yield the carrying (or book) value of the
bonds payable.
4. Amortizing a Bond Premium
a. Total bond interest expense incurred is the sum of the
interest payments less the bond premium.
b. Premiums must be systematically reduced (amortized) over
the life of the bond to report periodic interest expense
incurred.
c. Requires debiting Premium on Bonds Payable when bond
interest expense is recorded (payment and/or accruals) and
decreasing Interest Expense by the amortized amount.
d.Amortizing the premium decreases book value; at maturity,
book value = face value.
5. Straight-line method allocates an equal portion of the total
premium to bond interest expense in each of the six-month
interest periods.
E. Bond Pricing
The price of a bond is the present value of the bond’s future cash
flows discounted at the current market rate. Present value tables can
10-5
Chapter Outline Notes
be used to compute price, which is the combination of the:
1. Present value of the maturity payment (par value) is found by
using single payment table, the market rate, and number of
periods until maturity.
2. Present value of the semiannual interest payments is found by
using annuity table, the market rate, and number of periods until
maturity.
3. Present values found in present value tables in Appendix B at the
end of this book.
III. Bond Retirement
A. Bond Retirement at Maturity
1. Carrying value at maturity will always equal par value.
2. Entry to record bond retirement at maturity: debit Bonds
Payable, credit Cash.
B. Bond Retirement Before Maturity
1. Two common approaches to retire bonds before maturity:
a. Exercise a call option—pay par value plus a call premium.
b. Purchase them on the open market.
2. Difference between the purchase price and the bonds’ carrying
value is recorded as a gain (or loss) on retirement of bonds.
C. Bond Retirement by Conversion
Convertible bondholders have the right to convert their bonds to
stock. If converted, the carrying value of bonds is transferred to
equity accounts and no gain or loss is recorded.
IV. Long-Term Notes Payable
Notes are issued to obtain assets, such as cash. Notes are typically
transacted with a single lender, such as a bank.
A. Installment Notes—obligations requiring a series of periodic
payments to the lender.
1. Entry to record issuance of an installment note for cash: debit
Cash, credit to Notes Payable.
2. Payments include interest expense accruing to the date of the
payment plus a portion of the amount borrowed (principal).
a. Equal total payments consist of changing amounts of interest
and principal.
b. Entry to record installment payment: debit Interest Expense
(issue rate times the declining carrying value of note), debit
Notes Payable (for difference between the equal payment
and the interest expense), credit Cash for the amount of the
equal payment.
10-6
Chapter Outline Notes
B. Mortgage Notes and Bonds
A mortgage is a legal agreement that helps protect a lender if a
borrower fails to make required payments. A mortgage contract
describes the mortgage terms.
1. Accounting for mortgage notes and bonds—same as accounting
for unsecured notes and bonds.
2. Mortgage agreements must be disclosed in financial statements.
V. Global View—Compares U.S. GAAP to IFRS
1. Accounting for Bonds and Notes – The definitions and
characteristics of bonds and notes are broadly similar for both
GAAP and IFRS.
a. Both systems allow companies to account for bonds and notes
using the fair value option method. This method is similar to
that applied to measuring and accounting for debt and equity
securities.
b. Fair value is the amount a company would receive if it
settled a liability in an orderly transaction as of the balance
sheet date.
c. Companies can use several sources of inputs to determine fair
value which fall into three classes:
i. Level 1: observable quoted market price in active markets
for identical items
ii. Level 2: observable inputs other than those in Level 1
iii. Level 3: observable inputs reflecting a company’s
assumptions about value.
2. Accounting for Leases and Pensions – Both GAAP and IFRS
require companies to distinguish between operating leases and
capital leases; the latter is referred to as finance leases under
IFRS. Both systems account for leases in a similar manner. The
main difference is the criteria for identifying a lease as a capital
lease are more general under IFRS.
VI. Decision Analysis—Debt Features and the Debt-to-Equity Ratio
Collateral Agreements—reduce the risk of loss for both bonds and notes;
unsecured bonds and notes are riskier because the issuer’s obligation to
pay interest and principal has the same priority as all other unsecured
liabilities in the event of bankruptcy.
A. Features of Bonds and Notes
1. Secured or Unsecured
a. Secured bonds and notes have specific assets of the issuer
pledged (or mortgaged) as collateral.
b. Unsecured bonds and notes also called debentures, are backed
by the issuer’s general credit standing. Unsecured debt is
riskier than secured debt.
10-7
Chapter Outline
2. Term or Serial
a. Term bonds and notes are scheduled for maturity on one
specified date.
b. Serial bonds and notes mature at more than one date (often in
series) and are usually repaid over a number of periods.
3. Registered or Bearer
a. Registered bonds are issued in the names and addresses of
their holders. Bond payments are sent directly to registered
holders.
b. Bearer bonds, also called unregistered bonds, are made
payable to whoever holds them (the bearer). Many bearer bonds
are also coupon bonds; which are interest coupons that are
attached to the bonds.
4. Convertible and/or Callable
a. Convertible bonds and notes can be exchanged for a fixed
number of shares of the issuing company’s common stock.
b. Callable bonds and notes have an option exercisable by the
issuer to retire them at a stated dollar amount before maturity.
B. Debt-to-Equity Ratio
1. Knowing the level of debt helps in assessing the risk of a
company’s financing structure.
2. A company financed mainly with debt is riskier than a company
financed mainly with equity because liabilities must be repaid.
3. Debt-to-equity ratio measures the risk of a company’s financing
structure.
Notes
4. Debt-to-equity ratio is computed by dividing total liabilities by
total equity.
VI. Present Values of Bonds and Notes (Appendix 10A)
A. Present Value Concepts
1. Cash paid (or received) in the future has less value now than the
same amount of cash paid (or received) today.
2. An amount borrowed equals the present value of the future
payment(s).
3. Compounded interest means that interest during a second period
is based on the total of the amount borrowed plus the interest
accrued from the first period.
4. Present Value tables can be used to determine the present value
of future cash payments of a single amount or an annuity.
B. Present Value Tables (Complete tables in Appendix B)
1. Present values can be computed using a formula or a table.
2. Present value of $1 table is used to compute present value of a
single payment.
10-8
Chapter Outline Notes
3. Present value of an annuity of $1 table is used to compute
present value of a series of equal payments (annuity).
C. Applying a Present Value Table (Complete tables in Appendix B)
1. Determine the column with the interest rate.
2. Determine the row with the periods hence.
3. The column and row will intersect at the factor number.
4. To convert the single payment to its present value, multiply this
amount by the factor.
D. Present Value of an Annuity (Complete tables in Appendix B)
1. Determine the column with the interest rate.
2. Determine the row with the number of periods.
3. The column and row will intersect at the factor number.
4. To convert the annuity to its present value, multiply the annuity
amount by the factor.
E. Compounding Periods Shorter than a Year
1. Interest rates are generally stated as annual rates.
2. They can be allocated to shorter periods of time.
VII. Effective Interest Amortization (Appendix 10B)
A Effective Interest Amortization of a Discount Bond
1. The straight-line method yields changes in the bonds’ carrying
value while the amount for bond interest expense remains
constant. (Total interest expense/ # interest periods)
2. The effective interest method allocates total bond interest
expense over the bonds’ life in a way that yields a constant rate
of interest.
3. The key difference between the two methods lies in computing
bond interest expense. Instead of assigning an equal amount of
bond interest expense in each period, the effective interest
method assigns a bond interest expense amount that increases
over the life of a discount bond.
4. Both methods allocate the same amount of bond interest expense
to the bonds’ life, but in different patterns.
5. Except for differences in amounts, journal entries recording the
expense and updating the Discount on Bonds Payable account
balance are the same under both methods.
B Effective Interest Amortization of a Premium Bond
1. As noted above, the effective interest method allocates total
bond interest expense over the bonds’ life in a way that yields a
constant rate of interest.
2. Except for differences in amounts between the two methods (that
is, the straight-line and effective interest methods), journal
entries recording the expense and updating the Premium on
Bonds Payable account are the same under both methods.
10-9