Chapter 10 – Reporting and Analyzing Long-Term Liabilities
10-1
Chapter 10
Reporting and Analyzing Long-Term Liabilities
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
(A &B set)**
Beyond the
Numbers
Conceptual objectives:
C1. Explain the types and payment
patterns of notes.
15, 16
10-9
10-14
10-9
C2. Explain and compute the
present value of an amount to
be paid at a future date.
(Appendix 10A)
10-19
C3. Describe interest accrual when
bond payment periods differ
from accounting periods.
(Appendix 10C)
10-19
C4. Describe the accounting for
leases and pensions.
(Appendix 10D)
18, 19, 20
10-12, 10-13
10-12, 10-17,
10-18, 10-19
10-11
EC
Analytical objectives:
A1. Compare bond financing with
stock financing.
1, 2, 3, 13
RIA, EC,
ED, HTN
A2. Assess debt features and their
implications.
4, 5, 6
10-8, 10-10
RIA, TTN
A3. Compute the debt-to-equity
ratio and explain its use.
12, 17
10-16
10-10
CA, GD
Procedural objectives:
P1. Prepare entries to record bond
issuance and bond interest
expense.
7, 8, 9, 10,
11, 14
10-1, 10-2,
10-3, 10-4,
10-5, 10-11,
10-14, 10-15
10-1, 10-6,
10-7, 10-8,
10-12, 10-13,
10-20
10-1, 10-2,
10-3, 10-4,
10-5, 10-6,
10-7, 10-8
P2. Compute and record
amortization of bond discount
using straight-line method.
10-1, 10-5
10-2, 10-6,
10-7, 10-9,
10-11, 10-13
10-2, 10-6
TIA
P3. Compute and record
amortization of bond premium
using straight-line method.
10-4, 10-8
10-10
10-3, 10-4,
10-6
CIP, TIA
P4. Record the retirement of bonds.
10-6, 10-7
10-11
10-8
Grid continues on next page.
Chapter 10 – Reporting and Analyzing Long-Term Liabilities
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
(A &B set)**
Beyond the
Numbers
P5. Prepare entries to account for
notes.
10-14, 10-15
10-9
P6. Compute and record
amortization of bond discount
using effective interest method.
(Appendix 10B)
8
10-3
10-7, 10-8
P7. Compute and record
amortization of bond premium
using effective interest method.
(Appendix 10B)
8
10-2
10-5
10-5, 10-8
* Assignment materials that can be completed by students using:
Chapter 10 – Reporting and Analyzing Long-Term Liabilities
10-3
PowerPoint® Slides
Chapter Learning Objective
PowerPoint® Slides
A1
3-6
P1
7-10
P2
11-17
P3
18-23
P4
24-25
C1
26-30
P5
29, 31
A2
32
A3
33
C2
34-35
P6, P7
36
C3
37-41
Chapter 10 – Reporting and Analyzing Long-Term Liabilities
10-4
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.
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 insure they do
not violate any existing contractual agreements.
Chapter 10 – Reporting and Analyzing Long-Term Liabilities
10-5
Chapter Outline
Notes
1. Bond indenture is the contract between the bond issuer and the
bondholders. It specifies how often interest is paid and 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.
II. Bond Issuances
A. Issuing Bonds at Par—bonds are sold for face amount.
Entries are:
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.
Chapter 10 – Reporting and Analyzing Long-Term Liabilities
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Chapter Outline
Notes
4. Amortizing a Bond Discount
a. Total bond interest expense is the sum of the interest
payments and 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 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 10 – Reporting and Analyzing Long-Term Liabilities
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Chapter Outline
Notes
be used to compute price, which is the combination of the:
1. Present Value of a Discount Bond. Present value of the maturity
payment is found by using single payment table, the market rate,
and number of periods until maturity.
2. Present Value of a Premium Bond. 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.
B. Mortgage Notes and Bonds
A mortgage is a legal agreement that helps protect a lender if a
Chapter 10 – Reporting and Analyzing Long-Term Liabilities
10-8
Chapter Outline
Notes
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
A. Accounting for Bonds and Notes – The definitions and characteristics of
bonds and notes are broadly similar for both GAAP and IFRS.
1. 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.
2. Fair value is the amount a company would receive if it settled a
liability in an orderly transaction as of the balance sheet date.
3. Companies can use several sources of inputs to determine fair
value which fall into three classes:
a. Level 1: observable quoted market price in active markets for
identical items
b. Level 2: observable inputs other than those in Level 1
c. Level 3: observable inputs reflecting a company’s
assumptions about value.
B. 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. Lease accounting is changing in the next year or so.
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.
Notes