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Chapter 14 - Long-Term Liabilities
Chapter 14
C1. Explain the types and payment
patterns of notes.
1 14-11 14-10, 14-11,
14-20
14-6
C2. Explain and compute the
present value of an amount to
be paid at a future date.
(Appendix 14A)
C3. Describe interest accrual when
bond payment periods differ
from accounting periods.
(Appendix 14C)
14-16 14-15, 14-16 14-7
C4. Describe the accounting for
leases and pensions.
(Appendix 14D)
18, 19, 20 14-17, 14-18 14-17 14-11 14-3
Analytical objectives:
A1. Compare bond financing with
stock financing.
2, 3, 4, 5, 6,
7, 13, 15
14-1 14-1, 14-3,
14-7, 14-8
A2. Assess debt features and their
implications.
16 14-12 14-1, 14-5
A3. Compute the debt-to-equity
ratio and explain its use.
12, 17 14-13 14-17 14-2, 14-9
P1. Prepare entries to record bond
issuance and bond interest
expense.
8, 9, 10, 11,
14
14-2, 14-3,
14-4, 14-5,
14-7, 14-19,
14-20
14-1, 14-4,
14-5, 14-6,
14-16
14-1, 14-2,
14-3, 14-4,
14-5, 14-8,
14-9, 14-10
P2. Compute and record
amortization of bond discount.
14-6, 14-7 14-2, 14-3,
14-4, 14-5,
14-9, 14-15
14-2, 14-5 14-6
P3. Compute and record
amortization of bond premium.
14-8 14-6, 14-7,
14-8
14-3, 14-4,
14-5
14-4, 14-6
P4. Record the retirement of bonds. 14-9, 14-10 14-9, 14-18,
14-19
14-10
This grid is continued on next page
14-1
Chapter 14 - Long-Term Liabilities
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 14B)
14-14 14-13 14-8, 14-10
P6. Compute and record
amortization of bond premium
14-15 14-14 14-9, 14-10
14-4A, 14-8A, 14-10A, 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
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
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Chapter 14 - Long-Term Liabilities
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.
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.
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
14-3
Chapter 14 - Long-Term Liabilities
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),
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.
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
5. Straight-line method—allocates an equal portion of the total
1. The premium on bonds payable is the difference between the
par value of a bond and its higher issuance price.
14-4
Chapter 14 - Long-Term Liabilities
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
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
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
14-5
Chapter 14 - Long-Term Liabilities
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.
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
14-6
Chapter 14 - Long-Term Liabilities
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
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.
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
4. Convertible and/or Callable
a. Convertible bonds and notes can be exchanged for a fixed
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
14-7
Chapter 14 - Long-Term Liabilities
4. Debt-to-equity ratio is computed by dividing total liabilities by
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.
Chapter Outline Notes
3. Present value of an annuity of $1 table is used to compute
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.
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
14-8
Chapter 14 - Long-Term Liabilities
3. The key difference between the two methods lies in computing
bond interest expense. Instead of assigning an equal amount of
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.
Chapter Outline Notes
VIII. Issuing Bonds Between Interest Dates (Appendix 14C)
A. Procedure used to simplify recordkeeping:
1. Buyers pay the purchase price plus any interest accrued since the
prior interest payment date.
2. This accrued interest is repaid to these buyers on the next
interest date.
3. Entry to record issuance of bonds between interest dates: debit
Cash, credit Interest Payable (for any interest accrued since the
prior interest payment date), credit Bonds Payable.
4. Entry to record first semiannual interest payment for bonds
issued between interest dates: debit Interest Payable (for amount
1. Necessary when bond’s interest period does not coincide with
issuer's accounting period.
2. Adjusting entry is necessary to record bond interest expense
accrued since the most recent interest payment and requires
amortization of the premium or discount for this period.
3. Affects the subsequent interest payment date entry.
IX. Leases and Pensions (Appendix 14D)
14-9
Chapter 14 - Long-Term Liabilities
operating leases are likely to be accounted for similar to capital
leases.
1. Operating leases are short-term (or cancelable) leases in which
2. Capital leases are long-term (or noncancelable) leases in which
the lessor transfers substantially all risks and rewards of
ownership to the lessee.
a. The lease must meet any one of the four following criteria:
i. Transfer title of leased asset to lessee.
ii. Contain a bargain purchase option.
iii. Have lease term of 75% or more of leased asset's useful
life.
iv. Have present value of lease payment of 90% or more of
leased asset’s market value.
Chapter Outline Notes
b. Failure to meet one of the criteria results in off-balance-
sheet financing (not recorded on the balance sheet)
c. Capital leases are recorded as assets and liabilities. The asset
is depreciated. At each lease payment date, the liability is
amortized to record interest expense incurred.
B. Pension Liabilities
A pension plan is a contractual agreement between an employer and
its employees for the employer to provided benefits (payments) to
employees after they have retired.
1. Employer records their payment into pension plan as a debit to
Pension Expense and a credit to Cash.
2. Based on contracted benefits, pension plans can be overfunded
(resulting in plan assets) or underfunded (resulting in plan
liabilities).
Alternate Demonstration Problem
Chapter Fourteen
Note: Instructor can choose the interest amortization method. Solution one
demonstrates the straight line method and solution two demonstrates the
effective interest method.
ABC Company issued $200,000 face value bonds on January 1, 2015, with
semiannual interest payments to be made on June 30 and December 31 at
14-10
Chapter 14 - Long-Term Liabilities
a contract rate of 10%. The bonds were scheduled to mature five years
after they were issued. On January 1, 2018, three years after the bonds
were issued, the company repurchased 40% of the outstanding bonds for
$79,000.
Required:
Part A
1. Assume that the bonds were issued when the market rate of interest
was 9%. Show calculation of issue price. If using the effective interest
method of amortization, prepare a schedule showing the bond interest
expense and amounts of amortization for the life of the bonds. If using
straight line, show the calculation of the periodic amortization within
the appropriate journal entries explanations.
2. Prepare the journal entry to record the bond issuance.
3. Prepare journal entries for the first two interest payments.
4. Prepare the journal entry to recognize the partial repurchase of the
bonds.
Part B
Redo Part A under the assumption that the market rate on the bonds when
issued was 16%.
14-11
