Financial and Managerial Accounting, 8e
10-1
Chapter 10
ACCOUNTING FOR LONG-TERM LIABILITIES
Related Assignment Materials
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
AA and
BTN
Conceptual objectives:
C1. Explain the types of notes and
prepare entries to account for
notes.
1
10-12
10-12, 10-13,
10-14
10-5
pricing. (Appendix 10A)
10-15, 10-16
10-16, 10-17
10-7
leases and pensions.
(Appendix 10C)
Analytical objectives:
A1. Compare bond financing with
stock financing.
2, 3, 4, 5, 6,
12, 14
10-1
10-1
SP
AA 10-1, BTN 10-1,
BTN 10-5, BTN 10-6
A2. Assess debt features and their
implications.
15
10-13
AA 10-1, BTN 10-3
A3. Compute the debt-to-equity
ratio and explain its use.
11, 16
10-14
10-15
10-6, SP
AA 10-2, AA 10-3
Procedural objectives:
P1. Prepare entries to record bond
issuance and interest expense.
10-4
discount using straight-line
method.
10-7, 10-8
10-17
method.
P4. Record the retirement of
bonds.
10-10, 10-11
10-4, 10-10,
9, 10, 13
10-2, 10-3,
10-2
Financial and Managerial Accounting, 8e
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prior written consent of McGraw-Hill Education.
10-2
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
AA and
BTN
P5.B Compute and record
amortization of a bond discount
using the effective interest
method. (Appendix 10B)
7
10-17
10-18
10-8
BTN 10-4
*See additional information on next page that pertains to these quick studies, exercises, and problems.
SP refers to the Serial Problem
AA refers to Accounting Analysis
BTN refers to Beyond the Numbers
GL refers to General Ledger Problems
Questions with Guided Example videos
Additional Information on Related Assignment Material
See Chapter 1 of the Instructor’s Resource Manual for more information on materials for this text available in
Connect.
Connect
Available on the instructor’s course-specific website, Connect:
• All numerical Quick Studies, all Exercises and Problems Set A.
o Connect also provides algorithmic versions for Quick Study, Exercises, and Problems.
Hints/Guided Examples
Please note that the Guided Examples are labeled as “Hints” in Connect assignments. The animated PowerPoints without
the video and audio functions for the Guided Examples are also available in the Connect Instructor Library and Exercise
Presentations. These are indicated in the Related Assignment Materials grid on page 1 in blue bold font.
Need-to-Know Videos
LO
Need–to-Know
Title
Time
P1
10-1
Recording Par Value Bonds
1:45
P2
10-2
Recording Discount Bonds
4:38
P3
10-3
Recording Premium Bonds
4:30
10-4
Recording Installment Note
3:45
Financial and Managerial Accounting, 8e
Concept Overview Videos
LO
Title
Time
C1
Explain the types of notes and prepare entries to account for notes.
Installment Notes
0:31
Mortgage Notes and Bonds
0:35
Equal Total Payments Pattern
2:29
Journal Entries for Interest
1:31
C2
Explain and compute bond pricing. (Appendix 10A)
Present Value of Discount Bonds
1:40
Present Value of Premium Bonds
1:07
C3
Describe accounting for leases and pensions. (Appendix 10C)
Operating Leases
0:57
Finance Leases
2:06
Pension Liabilities
1:07
A1
Compare bond financing with stock financing.
Bond Financing
2:16
Advantages of Bonds
1:39
Disadvantages of Bonds
0:54
A2
Assess debt features and their implications.
Common Features of Debt Securities Terms Part 1
1:07
Common Features of Debt Securities Terms Part 2
1:19
Compute the debt-to-equity ratio and explain its use.
1:49
P1
Prepare entries to record bond issuance and interest expense.
Par Bonds
0:56
P2
Compute and record amortization of a bond discount using straight-line method.
Issue Price, Contract Rate & Market Rate
2:11
Issuing Bonds at a Discount
2:13
Amortizing Discount Bonds
1:29
Amortizing Discount Bonds – Straight-line Method
1:38
Amortizing Discount Bonds -Carrying Value
2:22
P3
Compute and record amortization of a bond premium using straight-line method.
Issue Price, Contract Rate & Market Rate
2:10
Issuing Bonds at a Premium
2:05
Amortizing Premium Bonds
1:30
Amortizing Premium Bonds – Straight-line Method
1:40
Amortizing Premium Bonds -Carrying Value
2:21
P4
Record the retirement of bonds.
Bond Retirement at Maturity
0:37
Bond Retirement before Maturity
2:05
Financial and Managerial Accounting, 8e
10-4
Issuing Bonds at a Discount
2:17
Amortizing a Bond Discount
1:38
Amortizing a Bond Discount – Illustration
2:20
P6
Compute and record amortization of a bond premium using the effective interest
Issuing Bonds at a Premium
2:06
Amortizing a Bond Premium
1:33
Amortizing a Bond Premium – Illustration
2:22
Synopsis of Chapter Revisions
NEW opener—e.l.f. Cosmetics and entrepreneurial assignment.
Streamlined section on bond financing.
Updated IBM bond quote data.
Simplified numbers in Exhibit 10.7.
Simplified Exhibit 10.10 on premium bonds.
Simplified numbers in Exhibit 10.11.
Bond pricing moved to Appendix 10A.
Financial and Managerial Accounting, 8e
10-5
Chapter Outline
I. Basics of Bonds
Projects that need a lot of money often are financed with bonds.
A. Bond Financing
1. A bond is its issuer’s written promise to pay the par value of the bond with interest.
a. Most bonds require the issuer to make periodic interest payments.
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
funds than it pays in interest on those funds decreases its return on equity.
contrast, does not require any payments because cash withdrawals (dividends) are paid at the
B. Bond Issuing
Bond issuances state the number of bonds authorized, their par value, and the contract interest rate.
1. Bond indenture is the legal contract between the bond issuer and the bondholders; it identifies
the obligations and rights of each party. A bondholder may also
2. A bondholder may also receive a bond certificate is evidence of the company’s debt.
C. Bond Trading
1. Bonds are securities and can be readily bought and sold.
II. Par Bonds
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).
III. Discount Bonds
Financial and Managerial Accounting, 8e
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).
particular bond and its risk level.
B. 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. Recording Issuance of Discount Bonds—Entry to record issuance at a discount: debit Cash (issue
price), debit Discount on Bonds Payable (amount of discount); credit Bonds Payable (par value).
a. 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.
3. Amortizing Discount Bonds
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
over life).
4. Straight-line Method—allocates equal bond interest expense in each of the six-month interest
periods.
a. We divide the total bond interest expense by the number of semiannual periods in the bonds’
life.
b. During the bonds’ life, the discount decreases each period by the semiannual amortization
amount.
c. The carrying value increases each period by the amount of the semiannual amortization
amount.
IV. Premium Bonds
A. 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. Recording Issuance of Premium Bonds—Entry to record issuance at a premium: debit Cash
(issue price), credit Premium on Bonds Payable (amount of premium), credit Bonds Payable (par
value).
a. 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.
3. Amortizing Premium Bonds
Financial and Managerial Accounting, 8e
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.
4. Straight-line Method—allocates an equal portion of the total premium to bond interest expense in
each of the six-month interest periods.
B. Bond Retirement
1. Bond Retirement at Maturity
a. Carrying value at maturity will always equal par value.
b. Entry to record bond retirement at maturity: debit Bonds Payable, credit Cash.
a. Two common approaches to retire bonds before maturity:
3. 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.
V. Long-Term Notes Payable
Notes are issued to obtain assets, such as cash. Notes are usually issued to a single lender, such as a
bank.
A. Installment Notes—obligations requiring a series of periodic payments to the lender.
1. Issuance of Notes—Entry to record issuance of an installment note for cash: debit Cash, credit
to Notes Payable.
2. Payments of Principal and Interest—Payments include interest expense accruing to the date of
the payment plus a portion of the amount borrowed (principal).
B. Mortgage Notes and Bonds
A mortgage is a legal agreement that helps protect a lender if a borrower does not 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.
VI. Decision Analysis—Debt Features and the Debt-to-Equity Ratio
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.
Financial and Managerial Accounting, 8e
b. Serial bonds and notes mature at more than one date (often in series) and are usually repaid
over a number of periods.
c. Sinking fund bonds reduce the holder’s risk by requiring the issue to set aside assets to pay
debt in a sinking fund.
3. Registered or Bearer
4. Convertible and/or Callable
a. Convertible bonds and notes can be exchanged for a fixed number of shares of the issuing
company’s common stock.
b. Callable bonds and notes have an option exercisable by the issuer to retire them at a stated
dollar amount before maturity.
B. Debt-to-Equity Ratio
3. Debt-to-equity ratio measures the risk of a company’s financing structure.
4. Debt-to-equity ratio is computed by dividing total liabilities by total equity.
VII. Bond Pricing (Appendix 10A)
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 be used to compute price, which is the combination of the:
1. Present value of the maturity payment (par value) is found by using single payment 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.
VIII. Effective Interest Amortization (Appendix 10B)
A. Effective Interest Amortization of Discount Bonds
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 expense over the bonds’ life in a way
that yields a constant rate of interest.
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 Premium Bonds
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.
10-9
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.
IX. Leases and Pensions (Appendix 10C)
A. Lease Liabilities
A lease is an agreement between a lessor (owner) and a lessee (renter or tenant) that gives the lessee
the right to use the asset for a period of time in return for cash (rent) payments.
Leases are either finance leases or operating leases. Lessee records a “Right-of-Use Asset” and
“Lease Liability” equal to the present value of lease payments.
1. Finance leases are long-term leases where the lessee receives substantially all remaining
benefits of the asset. Similar to financing an asset purchase.
a. A finance lease must meet one or more of five criteria:
iv. Present value of lease payments equals or exceeds
substantially all of leased asset’s fair value.
v. Lease asset is specialized and expected to have no alternative use to lessor at lease-end.
2. Operating leases are long-term leases which do not meet any of the five criteria for finance
leases.
a. Lessee records lease payments as expenses.
b. Lessor records lease payments as revenues.
B. Pension Liabilities
A pension plan is an agreement for the employer to provide 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. Defined Benefit Plan gives workers defined future benefits.
Financial and Managerial Accounting, 8e
10–10
Chapter 10 Alternate Demonstration Problem
Note: Instructor can choose the interest amortization method. Solution one
demonstrates the straight-line method and solution two demonstrates the effective
interest method.
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.
10–11
Chapter 10 Solution One: Alternate Demonstration Problem
Using Straight-line Interest Method of Amortization
1. Calculation of cash received upon issuance of bonds (issue price):
Present value of $200,000 to be
received in 10 periods, discounted
at 4.5% per period
$200,000 × .6439 =
$128,780
Present value of $10,000 to be
received periodically for 10 periods,
discounted at 4.5% per period
$10,000 × 7.9127 =
79,127
$207,907
2.
1/1/19
Bonds Payable ………………………………………..
Premium on Bonds Payable …………………….
3.
6/30/19
Bond Interest Expense …………………………………
9,309.30
Premium on Bonds Payable ………………………….
790.70
Cash ……………………………………………………….
10,000.00
(7,907 / 10 periods = 790.70 per period)
12/31/19
Bond Interest Expense …………………………………
9,309.70
Premium on Bonds Payable
790.70
Cash ……………………………………………………….
10,000.00
4.
1/1/22
Bonds Payable ……………………………………………..
80,000.00
Premium on Bonds Payable ………………………….
Cash ……………………………………………………….
79,000.00
Gain on the Retirement of Bonds …………….
2,265.12**
** $80,000 + 1265.12 = 81265.12 Carrying Value −
Redemption Price $79,000 = Gain $2,265.12
10–12
Part B
1. * Calculation of cash received upon issuance of bonds (issue price):
Present value of $200,000 to be
at 8% per period
Present value of $10,000 to be
2.
1/1/19
Cash …………………………………………………………….
159,741
Discount on Bonds Payable ………………………….
40,259
Bonds Payable ………………………………………..
200,000
3.
6/30/19
Bond Interest Expense …………………………………
14,025.90
Discount on Bonds Payable …………………….
4,025.90
Cash ……………………………………………………….
10,000.00
(40,259/10 periods = 4,025.90 per period)
4.
12/31/19
Bond Interest Expense …………………………………
14,025.90
Discount on Bonds Payable …………………….
4,025.90
Cash ……………………………………………………….
10,000.00
1/1/22
Bonds Payable ……………………………………………..
80,000.00
5,441.44
Discount on Bonds Payable …………………….
6,441.44
Cash ……………………………………………………….
79,000.00
6,441.44)
** $80,000 − 6,441.44 = 73,558.56 Carrying
Value compared to Redemption Price $79,000
= Loss 5,441.44
10–13
Chapter 10 Solution Two: Alternate Demonstration Problem
Using Effective Interest Method of Amortization
1.
Period
Beginning
of Period
Carrying
Amount
Interest
Expense
to be
Recorded
Interest
to be Paid
to Bond-
holders
Premium
to be
Amortized
Unamortized
Premium end
of Period
End-of–
Period
Carrying
Amount
0
$7,907
$207,907
*
1
$207,907
$9,356
$10,000
$644
7,263
207,263
2
207,263
9,327
10,000
673
6,590
206,590
3
206,590
9,297
10,000
703
5,887
205,887
4
205,887
9,265
10,000
735
5,152
205,152
5
205,152
9,232
10,000
768
4,384
204,384
6
204,384
9,197
10,000
803
3,581
203,581
7
203,581
9,161
10,000
839
2,742
202,742
8
202,742
9,123
10,000
877
1,865
201,865
9
201,865
9,084
10,000
916
949
200,949
200,949
9,051
10,000
949
0
200,000
* Calculation of cash received upon issuance of bonds:
Present value of $200,000 to be
received in 10 periods, discounted
at 4.5% per period
$200,000 × .6439 =
$128,780
2.
1/1/19
Cash …………………………………………………………….
207,907
Bonds Payable ………………………………………..
200,000
Premium on Bonds Payable …………………….
7,907
3.
6/30/19
9,356
Premium on Bonds Payable ………………………….
12/31/19
Bond Interest Expense …………………………………
9,327
Premium on Bonds Payable ………………………….
673
Cash ……………………………………………………….
10,000
4.
1/1/22
Bonds Payable ……………………………………………..
Premium on Bonds Payable ………………………….
1,432
2,432
Part B
1.
Period
Beginning
of-Period
Carrying
Amount
Interest
Expense
to be
Recorded
Interest to
be Paid
to Bond-
holders
Discount
to be
Amortized
Unamortized
Discount end
of Period
End-of–
Period
Carrying
Amount
0
$40,259
$159,741
*
1
$159,741
$12,779
$10,000
$2,779
37,480
162,520
2
162,520
13,002
10,000
3,002
34,478
165,522
3
165,522
13,242
10,000
3,242
31,236
168,764
4
168,764
13,501
10,000
3,501
27,735
172,265
5
172,265
13,781
10,000
3,781
23,954
176,046
6
176,046
14,084
10,000
4,084
19,870
180,130
7
180,130
14,410
10,000
4,410
15,460
184,540
8
184,540
14,763
10,000
4,763
10,697
189,303
9
189,303
15,144
10,000
5,144
5,553
194,447
194,447
15,553
10,000
5,553
0
200,000
* Calculation of cash received upon issuance of bonds:
Present value of $200,000 to be
received in 10 periods, discounted
at 8% per period
$200,000 × .4632 =
$ 92,640
Present value of $10,000 to be
received periodically for 10 periods,
discounted at 8% per period
$10,000 × 6.7101 =
67,101
$159,741
10–15
2.
1/1/19
Cash …………………………………………………………….
159,741
Discount on Bonds Payable ………………………….
40,259
Bonds Payable ………………………………………..
200,000
3.
6/30/19
Bond Interest Expense …………………………………
12,779
Discount on Bonds Payable …………………….
2,779
Cash ……………………………………………………….
10,000
4.
12/31/19
Bond Interest Expense …………………………………
13,002
Discount on Bonds Payable …………………….
3,002
Cash ……………………………………………………….
10,000
1/1/22
Bonds Payable ……………………………………………..
80,000
6,948
Discount on Bonds Payable …………………….
7,948
Cash ……………………………………………………….
79,000