Summary
A bond is a security, usually long-term, that represents money that a corporation or some
other entity borrows from the investing public. Bondholders are considered creditors (not
owners) of the issuing corporation, who are entitled to periodic interest plus the principal of the
debt on some specied date. As is true for all corporate creditors, their claims for interest and
principal take priority over stockholders’ claims.
Bonds normally are due 10 to 50 years after issue, and interest is usually paid semiannually.
When bonds are issued, the organization executes a contract with the bondholders called a
bond indenture. In addition, the organization issues a bond certicate as evidence of its
indebtedness. A bond issue is made up of the total value of bonds issued at one time.
Bonds are usually issued in denominations of $1,000 or some multiple of $1,000 and have a
variety of features.
Bonds payable (along with any unamortized discounts or premiums) usually appear in the
long-term liabilities section of the balance sheet. However, bonds that will mature within one
year, and that will be retired with the use of current assets, are classied as current
liabilities. In addition, the important provisions of the bond indenture are disclosed in the
notes to the nancial statements.
When the face interest rate (or the rate paid on specic bonds) equals the market interest
rate for similar bonds on the issue date, the organization usually receives face value for the
bonds.
Regardless of the issue price, bondholders are entitled to interest based on the face amount.
Interest for a period is computed with the following formula:
Interest = Principal × Rate × Time
When the face interest rate is less than the market interest rate for similar bonds on the
issue date, the bonds usually sell at a discount (less than face value).
Unamortized Bond Discount is a contra-liability account to Bonds Payable in the balance
sheet. The di3erence between the two is called the carrying value, an amount that increases
as the discount is amortized, and that equals the face value of the bonds at maturity.
When the face interest rate is greater than the market interest rate for similar bonds on the
issue date, the bonds usually sell at a premium (greater than face value). Unamortized
Bond Premium is added to Bonds Payable on the balance sheet to produce the carrying
value.
00. Unsecured bonds (also called debenture bonds) are issued on a corporation’s general
credit, whereas secured bonds give the bondholders a claim to certain assets of the
organization on default.
00. When all the bonds of an issue mature on the same date, they are called term bonds.
When the bonds in an issue have several maturity dates, they are called serial bonds.
00. Some bonds may be bought back and retired by the company prior to their maturity
date, which is called early extinguishment of debt. Callable bonds give the issuer
the right to buy back and retire bonds before maturity at a call price, which is a
specied price usually above face value. Convertible bonds can be exchanged for
common stock or other securities at the option of the bondholder.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 2
00. When registered bonds are issued, the organization maintains a record of all
bondholders and pays interest by check to the bondholders of record. Coupon bonds
entitle the bearer to interest when the detachable coupons are presented at a bank for
collection.
Bond prices are expressed as a percentage of face value. For example, when bonds with a
face value of $100,000 are issued at 97, the company receives $97,000.
A separate account should be established for bond issue costs when they are material; these
are spread over the life of the bonds, often through the amortization of a discount (which
would be raised) or a premium (which would be lowered). In the examples, it is assumed
that bond issue costs increase the discount or decrease the premium.
The following journal entries related to bond issues are introduced in this section:
Cash XX (amount received)
Bonds Payable XX (face value)
Sold bonds at face value
Bond Interest Expense XX (amount incurred)
Cash (or Interest Payable) XX (amount paid or accrued)
Paid (or accrued) interest to bondholders
Cash XX (amount received)
Unamortized Bond Discount XX (amount of discount)
Bonds Payable XX (face value)
Sold bonds at a discount
Cash XX (amount received)
Unamortized Bond Premium XX (amount of premium)
Bonds Payable XX (face value)
Sold bonds at a premium
Theoretically, the value of a bond is equal to the sum of the present values of (1) the
periodic interest payments and (2) the single payment of principal at maturity. The discount
rate used is based on the current market rate of interest. Tables 1 and 2 in the appendix on
present value tables should be used in making these computations.
When bonds are issued at a discount or premium, the interest payments will not equal the
(true) total interest cost. Instead, total interest cost equals (1) interest payments over the
life of the bond, plus (2) the original discount amount or minus (3) the original premium
amount.
A zero coupon bond is a promise to pay a xed amount at maturity, with no periodic
interest payments. Investor earnings consist of the large discount on issue, which in turn is
amortized by the issuing corporation over the life of the bond.
A discount on bonds payable is considered an interest charge that must be amortized
(spread out) over the life of the bond. Amortization is generally recorded on the interest
payment dates, using either the straight-line or the e3ective interest method.
Under the straight-line method of amortization, the amount to be amortized each interest
period equals the bond discount divided by the number of interest payments during the life
of the bond.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 3
The e3ective interest method of amortization is more diDcult to apply than the straight-line
method, but it must be used when the results di3er signicantly.
To apply the eective interest method when a discount is involved, the market rate of
interest for similar securities when the bonds were issued (also called the e3ective rate of
interest) must rst be determined. This interest rate (halved for semiannual interest) is
multiplied by the existing carrying value of the bonds for each interest period to obtain the
bond interest expense to be recorded. The actual interest paid is then subtracted from the
bond interest expense recorded, to obtain the discount amortization for the period. Because
the unamortized discount is now less, the carrying value is greater. This new carrying value
is applied to the next period, and the same amortization procedure is applied.
Amortization of a premium acts as an o3set against interest paid in determining interest
expense to be recorded. Under the straight-line method, the premium to be amortized in
each period equals the bond premium divided by the number of interest payments during
the life of the bond.
The e3ective interest method is applied to bond premiums in the same way that it is applied
to bond discounts. The only di3erence is that the amortization for the period is computed by
subtracting the bond interest expense recorded from actual interest paid (the reverse is
done for amortizing a discount).
The following journal entries related to amortization are introduced in this section:
Bond Interest Expense XX (amount incurred)
Unamortized Bond Discount XX (amount amortized)
Cash (or Interest Payable) XX (amount paid or accrued)
Paid (or accrued) interest to bondholders and
amortized the discount
Bond Interest Expense XX (amount incurred)
Unamortized Bond Premium XX (amount amortized)
Cash (or Interest Payable) XX (amount paid or accrued)
Paid (or accrued) interest to bondholders
and amortized the premium
When the market rate for bond interest drops, a company may decide to call its bonds and
substitute debt with a lower interest rate. When bonds are called (for whatever reason), an
entry is needed to eliminate Bonds Payable and any unamortized premium or discount and
to record the payment of cash at the call price. In addition, any gain or loss on the
retirement of the bonds is recorded.
When a bondholder converts his or her bonds into common stock, the common stock is
recorded by the company at the carrying value of the bonds. Specically, the entry
eliminates Bonds Payable and any unamortized discount or premium and records Common
Stock and Paid-in Capital in Excess of Par Value, Common; no gain or loss is recorded.
The early extinguishment of debt is journalized in the following entry. Any gain or loss would
be treated as extraordinary.
Bonds Payable XX (face value)
Unamortized Bond Premium XX (current credit
balance)
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 4
Loss on Retirement of Bonds XX (loss)
Cash XX (amount paid)
Retired bonds at a loss
Bonds Payable XX (face value)
Unamortized Bond Premium XX (current credit
balance)
Cash XX (amount paid)
Gain on Retirement of Bonds XX (gain)
Retired bonds at a gain
The following journal entry illustrates the conversion of bonds into common stock:
Bonds Payable XX (face value)
Unamortized Bond Premium XX (current credit
balance)
Common Stock XX (par value)
Additional Paid-in Capital XX (excess of par)
Converted bonds into common stock
(Note: No gain or loss recorded; also,
an unamortized bond discount would have
been credited in this entry.)
When bonds are issued between interest dates, the interest that has accrued since the last
interest date is collected from the investor on issue and returned to the investor (along with
the interest earned) on the next interest date.
When the accounting period ends between interest dates, the accrued interest and the
proportionate discount or premium amortization must be recorded.
The following related journal entries are introduced in this section:
Cash XX (amount received)
Bond Interest Expense XX (accrued amount)
Bonds Payable XX (face value)
Sold bonds at face value plus accrued interest
(see next entry)
Bond Interest Expense XX (six months’ amount)
Cash (or Interest Payable) XX (amount paid or accrued)
Paid (or accrued) semiannual interest on bonds
in preceding entry
Bond Interest Expense XX (amount accrued)
Unamortized Bond Premium XX (amount amortized)
Bond Interest Payable XX (amount to be paid)
To record accrual of interest on bonds
payable and amortization of the premium
(year–end accrual)
Bond Interest Expense XX (amount incurred)
Bond Interest Payable XX (amount accrued)
Unamortized Bond Premium XX (amount amortized)
Cash XX (amount paid)
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 5
Paid semiannual interest including interest
previously accrued, and amortized the
premium
for the period since the end of the scal year
Long-term leases are classied as capital leases if the lease meets all of the following
conditions:
It cannot be cancelled
Its duration is about the same as the useful life of the asset
It stipulates that the lessee has the option to buy the asset at a nominal price at the
end of the lease.
Capital leases are more like a purchase or sale on installment than a rental. The lessee
records depreciation on the assets and records a long-term liability for the present value of
the total lease payments during the lease term. Similarly to a mortgage, each lease
payment includes both interest and principal. Exhibit 8 presents a payment schedule for a
capital lease and the text presents journal entries for recording the lease obligation,
depreciation, and the lease payment.
Pension liabilities occur when employer pension plans do not have suDcient assets to cover
the present value of their pension obligations. There are two types of pension plans; dened
contribution plans, and dened benet plans. Under a dened contribution plan, the
employer makes a xed annual contribution, usually as a percentage of the employee’s
gross pay. Employees control their investment accounts and assume the risk that their
pension assets will earn a suDcient return to meet their retirement needs. In a dened
benet plan, the employer assumes the risk that the pension assets will earn a suDcient
return to meet the retirement needs of the employees. In a dened contribution plan, the
employer generally does not have a pension liability aside from the current year
contribution. In a dened benet plan, it is possible for the employer to have a pension
liability, however, the intricacies are reserved for advanced courses.
Relevant Examples and Exhibits
Example: Bonds Issued at Face Value
Example: Bonds Issued at a Discount
Example: Bonds Issued at a Premium
Exhibit 2 Using Present Value to Value a $20,000, 9 Percent, Five-Year Bond
Example: Market Rate Above Face Rate
Example: Market Rate Below Face Rate
Example: Interest Expense for Bond Issued at a Discount
Example: Amortizing a Bond Discount Using the Straight-Line Method
Example: Amortizing a Bond Discount Using the E3ective Interest Method
Exhibit 3 Interest and Amortization Table of a Bond Discount: E3ective Interest
Method
Exhibit 4 Carrying Value and Interest Expense—Bonds Issued at a Discount
Example: Interest Expense for Bond Issued at a Premium
Example: Amortizing a Bond Premium Using the Straight-Line Method
Example: Amortizing a Bond Premium Using the E3ective Interest Method
Exhibit 5 Interest and Amortization Table of a Bond Premium: E3ective Interest
Method
Exhibit 6 Carrying Value and Interest Expense—Bonds Issued at a Premium
Example: Retirement of Bonds
Example: Conversion of Bonds to Common Stock
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 6
Example: Bonds Issued Between Interest Payment Dates
Example: Interest Payment for Bonds Issued Between Interest Payment Dates
Exhibit 7 Interest Expense When Bonds are Issued Between Interest Dates
Example: Year-End Accrual of Bond Interest Expense When Year-End Falls Between
Bond Interest Dates
Example: Payment of Interest When the Interest Payment Date Falls After Year-End
Accrual
Exhibit 8 Payment Schedule on an 8 Percent Capital Lease
Example: Capital Lease Recognition
Example: Depreciation Recorded
Example: Lease Payment
Exhibit 9 Long-Term Liabilities on the Balance Sheet
Teaching Strategy
Ask students to explain the di3erences between stocks and bonds. Then have them list and
explain the various features of bonds. If possible, get sample copies of bond certicates for
students to see. Short Exercise 3 and Exercise 2A cover bond features and characteristics.
Show that a bond appears in the long-term liabilities section of a balance sheet, just as a
building appears in the long-term assets section. Note that the building net of accumulated
depreciation is referred to as book value or carrying value and that the same terms are used
for bonds. Distinguish between subtracting the Discount account balance and adding the
Premium account balance to get the carrying value.
Explain bonds sold at a discount by asking: What will we need to do to get anyone to buy
our bonds if other available bonds pay 10 percent and our bonds pay 9 percent? (Lower the
price.) The reverse is true of a premium because of supply and demand.
To illustrate how bond prices move inversely with the market rate of interest, show face
amount of bond: $1,000; face interest rate: 10 percent. Contract amount of interest paid per
year is $100.
Market Rate = Face
Rate
Interest Paid per Year:
$100 = 10
percent
Amount Paid for Bond:
$1,000
Market Rate = 5
percent
Interest Paid per Year:
$100 = 5 percent
Amount Paid for Bond:
$2,000
Market Rate = 20
percent
Interest Paid per Year:
$100 = 20
percent
Amount Paid for Bond:
$500
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 7
Illustrate each of the three entries for issuing bonds. Case 2 provides a good illustration of
interest rates and market prices.
Demonstrate valuing bonds using present value. Short Exercise 4 and Exercises 3A, 4A, and
5A apply these concepts.
Reiterate that a bond discount is really additional interest, whereas a bond premium
represents an oset against interest. Explain, however, that the premium and discount must
be “spread out” over the life of the bond in accordance with the matching principle.
Emphasize that although the straight-line method is easier to apply than the e3ective
interest method, it is inferior. Students may have diDculty grasping the concept of the
e3ective interest method. Premium amortization, for example, is analogous to mortgage
payments (part principal and part interest, where the interest portion decreases each
period). Work through several examples with Short Exercises 5 and 6 or Exercises 6A
through 9A.
Demonstrate the year-end accrual of bond interest using Short Exercise 7.
For bond retirements, compare the retirement of bonds to the sale of a long-term asset with
accumulated depreciation. The entry to retire a bond with a discount is a mirror image
because Bonds Payable is on the opposite side of the balance sheet.
Use Exercise 10A to illustrate the entry. Note that if the bond has been sold at a premium,
the entry is similar to the one in the body of the text.
For bond conversions, note the similarities between the journal entries for bond retirements
and those for bond conversions—stock takes the place of cash, and Paid-in Capital in Excess
of Par Value takes the place of the Gain account.
Some students have diDculty calculating the conversion. Use Exercise 11A to explain a bond
conversion.
Review with students the way corporations pay interest to bondholders on the payment
date and why they do it.
Illustrate bonds being issued between interest payment dates and the year-end adjusting
entry by using a time line. Use the examples in the text and Exercises 14A and 15A.
If students are confused by crediting Bond Interest Expense when the bond is issued,
illustrate the same principle using Bond Interest Payable. Then show the rst interest
payment following the issue. To avoid confusing students, use only bonds sold at par on
other than an interest payment date.
Calculate the present value of a lease and demonstrate the journal entries related to capital
leases. Exercise 17A can be used for the demonstration.
Section 3: Business Applications
Business Applications
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 8
Evaluate a company’s level of debt
oDebt to equity ratio
oInterest coverage ratio
Lecture Outline
I. A key management decision is the company’s mix of nancing choices.
A. Issuing common stock has two advantages over long-term debt:
1. It provides permanent nancing that does not have to be paid back.
2. Dividend payments are optional.
B. Issuing long-term debt has advantages over common stock:
1. Current stockholder control remains intact.
2. The interest is tax-deductible, whereas dividends are not.
3. It provides nancial leverage.
C. Debt-nancing may entail the following disadvantages:
1. High levels of debt expose a company to nancial risk.
2. Negative nancial leverage is possible if earnings from investments do not
exceed its interest payments.
D. Managers compute the debt to equity ratio to assess how much debt to carry.
1. Debt to Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity
2. The higher the ratio, the greater the nancial risk.
3. O3-balance-sheet nancing may be used to keep ratio low.
E. The interest coverage ratio measures the degree of protection a company has
from default on interest payments.
1. Interest Coverage Ratio = (Income Before Taxes + Interest Expense) ÷
Interest Expense
2. Most analysts want to see an interest coverage ratio of at least 3 or 4 times.
II. The best source of information concerning cash Rows about short- and long-term debt is
the nancing activities section of the statement of cash Rows.
Summary
Long-term debt is used to nance long-term assets and business activities that have
long-run earnings potential, such as research and development. The three chief
management considerations related to issuing long-term debt are (1) whether to take on
long-term debt, (2) how much long-term debt to carry, and (3) what type(s) will be most
practicable. Among the advantages of long-term debt nancing are (1) current common
stockholders do not relinquish any control, (2) interest on debt is tax-deductible, and (3)
nancial leverage may increase earnings.
Financial leverage is the ability to earn more on assets than is paid in interest on the debt
incurred to nance the assets. Disadvantages of long-term nancing are (1) interest and
principal must be repaid on schedule (nancial risk) and (2) nancial leverage can work
against a company if the earnings from its investments do not exceed its interest payments
(negative nancial leverage).
Financial leverage is measured by the debt to equity ratio. The debt to equity ratio is
calculated as follows:
Total Liabilities
Total Stockholders’ Equity
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 14: Long-Term Liabilities Instructor’s Manual, p. 9
A company can structure long-term debts in such a way that they do not appear on the
balance sheet, which is known as o-balance-sheet nancing.
In addition to the debt to equity ratio, another common measure of the risk a company is
taking with its debt is the interest coverage ratio, which is calculated as follows:
Income Before Taxes + Interest
Expense
Interest Expense
Relevant Examples and Exhibits
Ratio: Debt to Equity Ratio
Ratio: Interest Coverage Ratio
Teaching Strategy
Use Exercise 18A to demonstrate the interest coverage ratio. Case 6 can be used to interpret
the use of debt nancing and calculate the debt to equity ratio and interest coverage ratio.
Student Engagement Tactics
00. Assign Case 6 to small groups in class. Use previously established groups or assign
groups randomly. Each group should select a representative to speak for the group.
00. Be clear on the expected output of the learning activity. Identify questions to address
and determine whether written answers are necessary. For example, ask one person
from each group to present one alternative and explain why that alternative would be
best.
00. Elicit as many alternatives as possible for the class to consider. After each group has
presented one alternative, if time permits, ask if any other alternatives might be
available.
00. Allow groups one or two minutes to consider which alternative they prefer and why. Poll
the class as to their preferred response.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.