Chapter Outline
Teaching Notes
e. Reporting Bond Liabilities
i. The total face value of a bond plus any related
premium or minus any related discount is reported
in the liabilities section of the balance sheet.
Illustrated in Exhibit 10.5
ii. Carrying value—The amount of the bond liability,
after taking into account any premium or discount.
iii. To determine whether a bond will be issued at a
premium, at face value, or at a discount, consider
only the relationship between the stated interest
rate on the bond (what the bond pays in cash) and
the market interest rate (the return that bondholders
require).
Illustrated in Exhibit 10.6
5. Interest Expense
a. As time passes, a bond liability creates interest
expense, which is matched to each period in which the
liability is owed.
b. Because interest expense arises from a financing
decision (not an operating decision), it is reported
below the Income from Operations line on the
company’s income statement.
c. Interest on Bonds Issued at Face Value
i. When bonds have issued at face value, the process
of calculating and recording interest on bonds is
similar to that for Notes Payable.
ii. On 1/1/15, the company receives $100,000 for
bonds issued at their $1,000 face value. Assuming
no previous accrual of interest, the company has
incurred interest of $500 (or $100,000 × 6% ×
1/12) for the month ended 1/31/15.
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Interest Payable (L) +500; Interest Expense (E)
–500
iii. Record:
Interest Expense
500
Interest Payable
500
iii. When interest is paid, Interest Payable will be
decreased (with a debit) and Cash will be
decreased (with a credit).
d. Interest on Bonds Issued at a Premium
i. When bonds are issued at a premium, the bond
issuer receives more cash on the issue date than it
repays on the maturity date.
Amortizing a bond premium
illustrated in Exhibit 10.7
ii. The premium isn’t exactly “free money,” but rather
is a reduction in the company’s cost of borrowing.
Chapter Outline
Teaching Notes
iii. For accounting purposes, we match the reduced
borrowing cost to the periods in which the bond
remains unpaid.
iv. Bond amortization—Makes the Interest Expense
smaller than the actual interest payment and, at the
same time, causes the balance in Premium on
Bonds Payable to decline each period.
Procedures for amortizing
bond premiums are covered
Supplements 10A, 10B, and
10C.
e. Interest on Bonds Issued at a Discount
i. When bonds issue at a discount, the bond issuer
receives less cash on the issue date than it repays
on the maturity date.
Amortizing a bond discount
illustrated in Exhibit 10.8
ii. The discount is an increase in the company’s cost
of borrowing.
iii. For accounting purposes, we match the increased
borrowing cost to the periods in which the bond
remains unpaid.
iv. This amortization causes the Interest Expense to be
more than the interest payment and, at the same
time, causes Discount on Bonds Payable to
decrease each period.
6. Bond Retirements
a. Most bonds are retired (paid off) at maturity.
i. The company retires bonds with a payment equal
to their $100,000 face value.
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) –100,000; Bonds Payable (L) –100,000
iii. Record:
Bonds Payable
100,000
Cash
100,000
b. Early Retirement
i. A company with lots of cash often retires their
bonds early to avoid the related interest expense.
ii. Even companies that don’t have extra cash might
retire bonds early if interest rates have fallen since
the original bonds were issued.
• The companies would issue new bonds at the
lower interest rate and use the money they
receive from the new bonds to retire the old
ones before maturity.
• This decision reduces interest expense, which
increases future earnings.
Chapter Outline
Teaching Notes
iii. Financial effects: (1) cash is paid by the borrower,
(2) the borrower’s bond liability is eliminated, and
(3) either a gain arises or a loss is incurred.
• A gain arises if the cash that must be paid to
retire the bonds is less than the carrying value
of the bonds.
• A loss is incurred if the company has to pay
more than the carrying value of the bonds at
the time of retirement.
iv. The company retires $100,000 of bonds issued at
face value at a bond price of 102 for cash of
$102,000 (or $100,000 × 1.02).
• Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) –102,000; Bonds Payable (L) –
100,000; Loss on Bond Retirement (E) –2,000
• Record:
Bonds Payable
100,000
Loss on Bond
Retirement
2,000
Cash
102,000
v. Gains and losses on early bond retirements are
reported after Income from Operations on the
income statement.
vi. If the bonds had been issued below or above face
value, any premium or discount balance that
existed at the time of retirement would need to be
removed as well.
7. Types of Bonds—Two categories:
a. Those that describe the type of organization that
issued the bonds.
i. U.S. Treasury Department (“treasuries”)
ii. Bonds issued by municipal organizations
(“munis”)
iii. Corporations (“corporates”).
b. Those that describe specific features of the bond.
i. Backed by collateral (“secured”) or not
(“debentures”).
ii. Can be called in by the issuing corporation and
exchanged for cash (“callable”) or converted into
shares of its stock (“convertible”).
iii. Mature in a series of installments (“serial bonds”)
rather than all at once (“term bonds”)
iv. Include no periodic interest payments (“strips” and
“zero–coupon bonds”).
Chapter Outline
Teaching Notes
D. Contingent Liability––Potential liability that has arisen as a
result of a past transaction or event; ultimate outcome will
not be known until a future event occurs or fails to occur.
1. Contingent liabilities are different than other liabilities
because their dependence on a future event introduces a
great deal of uncertainty.
2. Likelihood of liability and whether amount can be
reasonably estimated determine reporting:
Summarized in Exhibit 10.9
a. Probable and can be reasonably estimated—record the
liability and estimated loss.
b. Probable but cannot be reasonably estimated—
describe in financial statement notes.
The “Spotlight on the World”
feature addresses the concept
c. Reasonably possible—describe in financial statement
notes.
of certainty.
d. Remote—describe in financial statement notes.
III. Evaluate the Results
A. Debt-to-Assets Ratio
1. Debt-to-assets ratio––Indicates financing risk by
computing the proportion of total assets financed by
liabilities.
2. Debt-to–Assets Ratio = Total Liabilities ÷ Total Assets
3. Calculated to three decimal places and expressed as a
percentage by multiplying by 100.
4. Higher ratio suggests greater financing risk.
a. Raises possibility that company will not be able to
generate enough profit from its debt-financed business
to cover interest charged on its debt.
b. If the company defaults on its payments, it can be
forced into bankruptcy.
B. Times Interest Earned Ratio (fixed charge coverage ratio)
1. Times Interest Earned Ratio––Divides net income
before interest and taxes by interest expense to determine
the extent to which earnings before taxes and financing
costs are sufficient to cover interest incurred on debt.
The “Spotlight on The
World” feature addresses the
impact of violated loan
covenants.
2. Times Interest Earned Ratio = (Net Income + Interest
Expense + Income Tax Expense) ÷ Interest Expense.
3. Analysts want to know whether a company generates
enough income to cover its interest expense before the
costs of financing and taxes.
4. In general, a high times interest earned ratio is viewed
more favorably than a low one; a high ratio indicates an
extra margin of protection should the company’s
profitability decline in the future.
5. When less than 1.0, the company is not generating
enough operating income to cover its interest expense.
Chapter Outline
Teaching Notes
IV. Chapter Supplement 10A: Straight-Line Amortization
A. Straight-Line Method of Amortization—Reduces the
premium or discount by an equal amount each period.
1. Because this method results in an equal amount each
period, it is easy to apply.
2. However, it distorts the financial results somewhat
because it produces an equal Interest Expense each
period, even though the bond’s carrying value changes
each period.
3. For this reason, the straight-line method may be used only
when it does not materially differ from the effective-
interest method of amortization (presented in Supplement
10B).
B. Bond Premiums
✓ Activity #5
1. Under the straight-line method, the premium is spread
evenly as a reduction in interest expense over the life of
the bond (that is, the amount of the premium is divided by
the life to obtain the annual premium amortization).
2. The company would record the interest owed at the end
of the accounting period by increasing Interest Expense
(with a debit), decreasing Premium on Bonds Payable for
the amount of the amortization (with a debit), and
decreasing Cash for the amount to be paid to the
bondholder (with a credit).
3. This process continues until the bond matures, at which
point the Premium on Bonds Payable account will be
fully amortized to zero.
C. Bond Discounts
✓ Activity #4
1. Under the straight-line method, the discount is spread
evenly as a reduction in interest expense over the life of
the bond (that is, the amount of the discount is divided by
the life to obtain the annual discount amortization).
2. The company would record the interest owed at the end
of the accounting period by increasing Interest Expense
(with a debit), decreasing Discount on Bonds Payable for
the amount of the amortization (with a debit), and
decreasing Cash or the amount to be paid to the
bondholder (with a credit).
3. This process continues until the bond matures, at which
point the Discount on Bonds Payable account will be
fully amortized to zero.
Chapter Outline
Teaching Notes
V. Chapter Supplement 10B: Effective-Interest Amortization
A. Required by Generally Accepted Accounting Principles
1. Effective-Interest Method of Amortization––Allocates
the amount of bond premium or discount over each period
of a bond’s life in amounts corresponding to the bond’s
carrying value.
Computing present value of
bond payments illustrated in
Exhibit 10B.1
2. Considered a conceptually superior method of accounting
for bonds because it correctly calculates interest expense
by multiplying the true cost of borrowing times the
amount of money actually owed to lenders.
3. The true cost of borrowing is the market interest rate that
lenders used to determine the bond issue price.
B. Bond Premiums
✓ Activity #5
1. Interest expense for the year equals amount actually
borrowed (i.e., the carrying value or Bonds Payable plus
the Premium on Bonds Payable at the date of the
calculation) times the market interest rate for the year.
2. The difference between the interest expense and the
promised interest payment is the amount of premium that
is amortized.
3. The company would record the interest owed at the end
of the accounting period as described above for straight-
line amortization; the amounts recorded as Interest
Expense and Premium on Bonds Payable would be as
calculated above in 1 and 2.
4. The process continues until the bond matures, at which
point the Premium on Bonds Payable account will be
fully amortized to zero.
C. Bond Discounts
✓ Activity #4
1. Interest expense for the year equals amount actually
borrowed (i.e., the carrying value or Bonds Payable less
Discount on Bonds Payable at the date of the calculation)
times the market interest rate for the year.
Sample balance sheet
reporting illustrated in
Exhibit 10B.2
2. The difference between the interest expense and the
promised interest payment is the amount of discount that
is amortized.
3. The company would record the interest owed at the end
of the accounting period as described above for straight-
line amortization; the amounts recorded as Interest
Expense and Discount on Bonds Payable would be as
calculated above in 1 and 2.
4. The process continues until the bond matures, at which
point the Discount on Bonds Payable account will be
fully amortized to zero.
Chapter Outline
Teaching Notes
VI. Chapter Supplement C: Simplified Effective-Interest
Amortization
A. When using this simplified method, rather than record a
discount or premium in a separate account, it is combined
with the bonds payable in an account called Bonds Payable,
Net.
B. Accounting for Bond Issue
1. When bonds are issued at a premium, rather than record
the Bonds Payable at face value with a Premium on
Bonds Payable account, the two are combined in an
account called Bonds Payable, Net.
2. When bonds are issued at a discount, rather than record
the Bonds Payable at face value, with an offsetting
Discount on Bonds Payable account, the two are
combined in an account called Bonds Payable, Net.
3. One of the advantages of this simplified approach is that
there is no need to choose between the straight-line or
effective-interest method of amortization because there is
no discount or premium account to amortize.
C. Interest Expense
1. As time passes, the company incurs Interest Expense on
its bond liability.
2. Because the bond liability was recorded in a single
account, the interest calculation is the same whether the
bond has been issued at a premium or discount.
3. The following version of the interest formula is used to
compute Interest Expense:
Interest (I) = Principal (P) × Interest Rate (R) × Time (T)
or
Interest Expense = Bonds Payable, Net × Market Interest
Rate × n/12.
D. Bond Premiums
1. Because the cash interest payment exceeds the Interest
Expense, the company records a reduction in Bonds
Payable, Net.
2. Similar calculations and accounting effects occur each
period until the bonds mature.
a. The only thing to watch out for is that Bonds Payable,
Net decreases each year because the cash payment
includes a partial repayment of the bond liability.
b. This new balance is used to compute Interest Expense
for the following year.
Chapter Outline
Teaching Notes
E. Bond Discounts
1. Because the cash interest payment is less than the Interest
Expense, the company records an increase in Bonds
Payable, Net.
2. Similar calculations and accounting effects occur each
period until the bonds mature.
a. The only thing to watch out for is that Bonds Payable,
Net increases each year because the cash payment
includes a partial repayment of the bond liability.
b. This new balance is used to compute Interest Expense
for the following year.
Supplemental Enrichment Activities
Note: These activities would be suitable for individual or group activities.
1. Handout 10–1
Use Handout 10–1 for an in-class activity to review entries relating to payroll. The solution follows
the handout master.
2. Handout 10–2
Use Handout 10-2 for an in-class activity to review the issuance of a note payable. The solution
follows the handout master.
3. Handout 10–3
Use Handout 10–3 for an in-class activity to review the accounting for unearned revenues. The
solution follows the handout master.
4. Handout 10–4
Use Handout 10–4 for an in-class activity to review the issuance of bonds at a discount using both
straight-line and effective-interest amortization. The solution follows the handout master.
5. Handout 10–5
Use Handout 10–5 for an in-class activity to review the issuance of bonds at a premium using both
straight-line and effective-interest amortization. The solution follows the handout master.
HANDOUT 10–1
PAYROLL ENTRIES
J&W Buffet Co. employees earned $350,000 in the week ended December 17, 2016. Of this, $26,775 was
withheld from employees’ pay for FICA and $62,000 for income taxes. The net pay was directly
deposited into the employees’ bank accounts. The company must pay $200 for federal unemployment
taxes and $1,000 for state unemployment taxes.
Prepare the journal entry to record the employees’ portion of payroll for December 17, 2016.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity
Prepare the journal entry to record the employer payroll taxes for December 17, 2016.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity