978-1133939283 Chapter 14 Lecture Note Part 1

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Chapter 14

Long-Term Liabilities

Learning Objectives

1. Explain the concepts underlying long-term liabilities, and identify the types of long-term

liabilities.

2. Describe the features of a bond issue and the major characteristics of bonds.

3. Record bonds issued at face value and at a discount or premium.

4. Use present values to determine the value of bonds.

5. Amortize bond discounts and bond premiums using the straight-line and e(ective

interest methods.

6. Account for the retirement of bonds and the conversion of bonds into stock.

7. Record bonds issued between interest dates, and record year-end adjustments.

8. Explain and demonstrate the accounting issues related to leases and pensions.

9. Evaluate the decision to issue long-term debt, including analyzing long-term debt.

Section 1: Concepts

Concepts

Recognition

Valuation

Classi1cation

Disclosure

Lecture Outline

I. To 1nance assets and activities, companies incur long-term liabilities.

A. Long-term liabilities must be recognized when incurred, even though the

obligation may not be due for many years.

B. Long-term liabilities are generally valued at:

1. Amount of money needed to pay the debt.

2. The fair market value of the goods or services to be delivered.

C. A liability is classi1ed as long-term when it is due beyond one year or beyond

the normal operating cycle.

D. Extensive disclosures in the notes to the 1nancial statements are often

required.

II. The types of long-term debt include:

A. Bonds payable.

B. Notes payable.

C. Mortgages payable.

D. Other long-term obligations:

1. Capital leases

2. Pension liabilities

3. Other post-retirement bene1ts

4. Deferred income taxes

Summary

Long-term liabilities are debts and obligations that a company expects to satisfy in more

than one year or beyond its normal operating cycle, whichever is longer. GAAP requires that

long-term liabilities be recognized when an obligation occurs. On the balance sheet,

long-term liabilities are generally valued at the amount of money needed to pay the debt or

at the fair market value of the goods and services to be delivered. Extensive disclosures in

the notes to the 1nancial statements are often required for long-term liabilities because of

their complexities.

Bonds payable are the most common type of long-term debt. Long-term notes payable

are evidenced by a promissory note to a bank or other creditor that is due in more than one

year. A mortgage is a long-term debt, usually payable in equal monthly installments, that is

secured by real property. When a mortgage payment is made, both Mortgage Payable and

Mortgage Interest Expense are debited, and Cash is credited. Each month, the interest

portion of the payment decreases, and the principal portion of the payment increases.

A lease is a contract that allows a business or an individual to use an asset for a speci1c

length of time in return for periodic payments. An operating lease is a short-term lease

under which the risks of ownership remain with the lessor; it should be recorded only as a

rent expense for each period the asset is leased. A capital lease (as determined by certain

criteria) is in substance a sale and should be recorded as an asset (to be depreciated) and a

related liability by the lessee.

Pension liabilities arise from a contract that requires a company to pay bene1ts to its

employees after they retire. Bene1ts to retirees are usually paid out of a pension fund.

Pension plans are classi1ed as either de1ned contribution plans or de1ned bene1t plans.

Other post-retirement benets, such as for health care, should be estimated and accrued

while the employee is still working (in accordance with the matching rule).

Deferred income taxes may appear as a long-term liability on the balance sheet if

di(erent accounting methods are used to calculate income taxes on the income statement

versus income tax liability on the income tax return.

The following journal entry is introduced in this section:

Mortgage Payable XX (principal)

Mortgage Interest Expense XX (interest)

Cash XX (monthly payment)

Relevant Examples and Exhibits

Exhibit 1 Monthly Payment Schedule on a $100,000, 9 Percent Mortgage

Example: Mortgages Payable

Teaching Strategy

Explain that two sources of long-term funds are the issuance of common stock and the

issuance of long-term debt. Identify the forms that long-term debt may take: bonds, notes,

mortgages, and leases. Discuss reasons why a business may prefer to issue common stock.

Then identify advantages long-term debt has over common stock. Ask students to identify

reasons for this variability. Ask students to discuss the riskiness of carrying a large amount

of debt.

For mortgages payable, relate the concept to something familiar to students—for example,

note that a mortgage payable is handled in a manner similar to the loan on an automobile.

That is, each payment is divided between interest and principal. Use Exhibit 1 to review a

mortgage amortization schedule. Short Exercises 1 and 2 and Exercise 1A provide excellent

illustrations of these topics.

Section 2: Accounting Applications

Accounting Applications

Record bond issues at face value, at a discount, and at a premium

Value bonds

Amortize bond discounts and bond premiums

Record the retirement of bonds

Record the conversion of bonds into stock

Record bonds issued between the interest dates

Record year-end adjustments

Account for leases

Account for pensions

Lecture Outline

I. A bond is a security representing money borrowed from the investing public.

A. A bond indenture is a bond contract that speci1es the:

1. Maturity date.

2. Interest payment dates.

3. Interest rate.

B. A bond certi1cate is evidence of the corporation’s debt to the bondholders

C. A bond issue is the total value of bonds issued at one time.

1. Bond prices are expressed as a percentage of face value.

2. The face interest rate is a 1xed rate of interest based on the face value of the

bond.

3. The market interest rate is the e(ective interest rate.

4. A bond discount equals the excess of the face value over the issue price.

5. A bond premium equals the excess of the issue price over the face value.

D. Bonds can have many di(erent features.

1. Bonds can be either secured or unsecured (debenture).

2. 0Bond issues can be either term (all due at same date) or serial (portions

maturing at di(erent intervals).

3. 0Bonds may be callable and/or convertible.

a. Callable bonds may be bought back and retired before maturity. A

company might do this:

(1) To reissue the debt at a lower rate if market conditions have

changed.

(2) If it has been pro1table enough to pay back the debt.

(3) If the reason for having the debt no longer exists.

(4) If it wants to restructure its debt to equity ratio.

b. Convertible bonds may be exchanged for a speci1ed number of stock,

which usually allows them to be issued at a lower interest rate.

4. Bonds may be 0registered bonds or coupon bonds.

a. With registered bonds, a record of bondholders’ names and addresses is

maintained and interest payments are mailed to them.

b. With coupon bonds, bondholders present coupons to a bank for collection

on the interest payment dates.

II. Accounting for the issuance of bonds varies according to whether they are issued at

face, at a discount, or at a premium.

A. When bonds are issued at face value:

1. Cash is debited and Bonds Payable is credited.

2. Bond Interest Expense is debited when interest payments are made.

B. When bonds are issued at a discount:

1. Cash is debited cash received.

2. Unamortized Bond Discount is debited for amount of the discount.

3. Bonds Payable is credited for the face amount.

C. When bonds are issued at a premium:

1. Cash is debited for cash received.

2. Unamortized Bond Premium is credited for the amount of the premium.

3. Bonds Payable is credited for the face amount.

D. Bond issue costs:

1. Can amount to as much as 5 percent of the bond issue.

2. Include fees of underwriters.

III. A bond’s market value can be determined using the present value methods.

A. Sum the present value of:

1. The series of 1xed interest payments.

2. The single payment at maturity.

B. The current market rate of interest should be used for the computations.

C. If the market rate of interest is above the face rate, the bond will be worth

less than its face amount.

D. If the market rate of interest is below the face rate, the bond will be worth

more than its face amount.

IV. The bond discount or premium must be amortized over the life of the bond to bring its

carrying value to face value at maturity.

A. When amortizing a bond discount:

1. Total interest expense is equal to the total interest payments plus the bond

discount.

a. With zero coupon bonds, only the bond discount applies.

2. With the straight-line method, total interest expense is divided by number of

periods to determine amortization per period.

3. With the e(ective interest method, the amortization each period is equal to

the di(erence in interest computed with face rate and interest computed with

market rate at issue.

4. The journal entry will include a credit to Unamortized Bond Discount.

B. When amortizing a bond premium:

1. Total interest expense is equal to the total interest payments less the bond

premium.

2. The journal entry will include a debit to Unamortized Bond Premium.

V. A company can reduce its bond debt through retirement and/or conversion.

A. Bonds may be retired by calling them or by buying them from bondholders on

the open market.

1. In the journal entry, the Bonds Payable and Unamortized Bond Premium

accounts are debited to close balances associated with the bond issue, Cash

is credited for amount paid, and a gain or loss is recognized for any

di(erence.

B. When a bondholder converts bonds to common stock:

1. The issued common stock is recorded at the carrying value of the bonds.

2. No gain or loss is recognized.

VI. Other bonds payable issues arise with the sale of bonds between interest dates and

with year-end accruals.

A. When bonds are sold between interest dates:

1. Investors pay for the interest that would have accrued for the partial period.

2. On the interest date, full interest is paid as usual.

B. At year-end, adjusting entries include accrual of bond interest expense since

the last payment date.

1. This includes amortization of any discount or premium for the partial period.

2. On the payment date, the entry includes a debit to Bond Interest Payable and

amortization for the partial period since the adjusting entry.

VII. A company may obtain an operating asset through a long-term lease.

A. With a short-term operating lease, ownership remains with lessor.

B. A lease must be treated as a capital lease if all conditions are met:

1. It cannot be canceled.

2. Its duration is asset’s useful life.

3. The lessee has the option to buy at end of lease.

C. When accounting for a capital lease, the item leased must be recorded as an asset

and depreciated over time.

VIII. Most companies provide their employees with a pension plan.

A. If a pension plan has insuGcient assets to meet expected obligations, the

shortfall must be recorded as a liability.

B. There are two types of pension plans:

1. De1ned contribution plan:

(a) Employers contribute but employees control the investment accounts.

(b) Examples include 401(k), pro1t-sharing plans, and ESOPs.

(b) Annual pension expense is simple and predictable.

2. De1ned bene1t plan:

(a) The company has control of the investment accounts.

(b) The exact amount of the future liability is not known.

IX. Long-term liabilities are presented on the balance sheet as shown in Exhibit 9.