231
chapter
12
Long-Term Liabilities:
Bonds and Notes
______________________________________________
OPENING COMMENTS
The subject of long-term liabilities and bonds is a challenge for most students. This chapter requires
students to apply difficult concepts that most of them have not encountered before. For example, present
value and amortization of bond discounts and premiums are covered in the appendices to the chapter.
Before attacking bond problems that require the use of present value tables, take the time to explain this
new concept thoroughly and to demonstrate several applications of present value techniques. This will
make present value meaningful and will ease its application to bonds.
After studying the chapter, your students should be able to:
2. Describe the characteristics and terminology of bonds payable.
4. Describe and illustrate the accounting for installment notes.
6. Describe and illustrate how the number of times interest charges are earned is used to evaluate a
company’s financial condition.
232 Chapter 12 Long-Term Liabilities: Bonds and Notes
KEY TERMS
amortization
annuity
bond
bond indenture
carrying amount
contract rate
discount
earnings per share (EPS)
effective interest rate method
effective rate of interest
face amount
STUDENT FAQS
• Why do we need to study bonds when 99.9 percent of us will never be dealing with bonds because
we are not accounting majors?
• Is the current interest rate on bonds going up or down now?
• Why would a company want to call bonds in and incur a loss?
• Which interest rate do we use when we go to the tables?
Chapter 12 Long-Term Liabilities: Bonds and Notes 233
OBJECTIVE 1
Compute the potential impact of long-term borrowing on earnings per share.
SYNOPSIS
Corporations finance their operations using short– or long-term debt or with equity by selling stock.
Short-term debt includes the purchase of goods and services on account and the issuance of short-term
notes. Issuing equity by selling stock was discussed in Chapter 11. Issuing bonds is a way to finance large
sums of money long term. A bond is an interest-bearing note that requires periodic interest payments and
the face value is repaid at maturity. Bondholders are creditors, and as such, their claim on assets ranks
ahead of stockholders. When in need of financing, a corporation faces a decision to issue stock or bonds.
Key Terms and Definitions
• Bond – A form of an interest-bearing note used by corporations to borrow on a long-term basis.
• Earnings per Share (EPS) – Net income per share of common stock outstanding during a period.
Relevant Example Exercises and Exhibits
• Example Exercise 12-1 Alternative Financing Plans
• Exhibit 1 – Effect of Alternative Financing Plans—$800,000 Earnings
• Exhibit 2 – Effect of Alternative Financing Plans—$440,000 Earnings
SUGGESTED APPROACH
In this objective, you need to sensitize students to the trade-offs between equity and debt financing. Since
these terms are not explicitly stated in the text, be sure to clearly define equity financing and debt
financing. Notes to assist you with this discussion are included below.
234 Chapter 12 Long-Term Liabilities: Bonds and Notes
Point out that the U.S. government uses bonds to finance its operations. U.S. Treasury bonds and U.S.
savings bonds are debt securities issued by our government.
LECTURE AID—Risk and Return
This degree of detail regarding risk and return does not appear in the text for this objective, but you may
wish to elaborate on factors to consider that are implied in the text at this time.
Ask students the following questions to introduce the relationship between risk and return:
How many of you buy lottery tickets? Why do you buy them? By a show of hands, how
many of you would buy a $1 lottery ticket if the jackpot were $1 million? How many of
Hopefully, your students will point out that interest earned on a savings account is a sure bet, whereas
winning the lottery is a long shot. This story illustrates the relationship between risk and reward. The
riskier an investment, the greater the reward an investor expects if his or her investment pays off.
When a company is considering whether to raise funds by selling stock (equity) or issuing bonds (debt), it
must balance the following information:
1. Debt funding is cheaper than equity funding. Because shareholders accept more risk than creditors
2. Debt funding uses leverage to increase shareholder returns. Purchasing additional assets through debt
3. Debt funding is riskier than equity funding. When sales and profits drop, a corporation can cease
paying dividends. However, it cannot cease its debt payments.
Chapter 12 Long-Term Liabilities: Bonds and Notes 235
OBJECTIVE 2
Describe the characteristics and terminology of bonds payable.
SYNOPSIS
A bond issue is normally divided into individual bonds with a face value of $1,000 or a multiple of
$1,000. The face value is called the principal; this is the amount that must be repaid at maturity. The
contract between the company issuing the bonds and the bond purchasers is called a bond indenture.
Key Terms and Definitions
• Bond Indenture – The contract between a corporation issuing bonds and the bondholders.
• Contract Rate – The periodic interest to be paid on the bonds that is identified in the bond
indenture; expressed as a percentage of the face amount of the bond.
• Discount – The interest deducted from the maturity value of a note or the excess of the face
Relevant Example Exercises and Exhibits
• Exhibit 3 – Issuing Bonds at a Discount, at Face Amount, and at a Premium
SUGGESTED APPROACH—Characteristics of Bonds
Use TMs 12-5 and 12-6 to review the characteristics of bonds and the types of bonds that may be issued.
Number 5 on TM 12–6 lists “Secured Bonds.” Note that while “secured” isn’t explicitly included in
Objective 2, it is implied in the first paragraph.
236 Chapter 12 Long-Term Liabilities: Bonds and Notes
Characteristics that increase Characteristics that decrease
the bondholder’s risk the bondholder’s risk
Term bonds Serial bonds
Callable bonds Convertible bonds
Debenture bonds Secured bonds
LECTURE AID—Convertible and Callable Bonds
Convertible bonds give the bondholder the right to exchange his or her bonds for shares of stock if certain
conditions exist. However, the bondholder chooses whether or not to convert. Bondholders convert bonds
only if it is to their benefit.
LECTURE AID—Proceeds from Issuing Bonds
Pose the following question to your class:
Assume that your bond has an interest rate of 10 percent when other bonds are paying 12
percent. Investors will not want to buy your bond if they can earn 12 percent elsewhere.
What can you do to get investors to buy your 10 percent bond? (Answer: lower the price)
You will need to drop the price of your bond so investors are really getting a 12 percent return. In other
words, you need to drop the price to the present value of the bond using a 12 percent interest rate. You
will need to sell the bond at a discount.
Chapter 12 Long-Term Liabilities: Bonds and Notes 237
OBJECTIVE 3
Journalize entries for bonds payable.
SYNOPSIS
When bonds are issued at face value or a price of 100, Cash is debited and Bonds Payable is credited. If
interest is to be paid semiannually, the interest payment is recorded as a debit to Interest Expense and a
credit to Cash. If the market rate is greater than the coupon rate, the bond will sell at a discount. This is
recorded as a debit to Cash and Discount on Bonds Payable, and Bonds Payable will be credited for the
full face value of the bonds issued. The bond discount must be amortized over the life of the bond. This is
Bonds may be redeemed at maturity, or callable bonds may be redeemed prior to maturity. Bonds
redeemed at maturity are recorded as a debit to Bonds Payable and a credit to Cash. If the bonds are
Key Terms and Definitions
• Amortization – The periodic transfer of the cost of an intangible asset to expense.
• Carrying Amount – The balance of the bonds payable account (face amount of the bonds) less
any unamortized discount or plus any unamortized premium.
• Effective Interest Rate Method – The method of amortizing discounts and premiums that
provides for a constant rate of interest on the carrying amount of the bonds at the beginning of
each period; often called simply the “interest method.”
Relevant Example Exercises and Exhibits
• Example Exercise 12-2 Issuing Bonds at Face Amount
• Example Exercise 12-3 Issuing Bonds at a Discount
• Example Exercise 12-4 Discount Amortization
• Example Exercise 12-5 Issuing Bonds at a Premium
• Example Exercise 12-6 Premium Amortization
• Example Exercise 12-7 Redemption of Bonds Payable
238 Chapter 12 Long-Term Liabilities: Bonds and Notes
DEMONSTRATION PROBLEM—Issuance of a Bond (Face Amount)
Using the following information, we can demonstrate the journal entries to record bonds issued at face
DEMONSTRATION PROBLEM—Issuance of a Bond (Discount)
The calculation for present value of bonds is covered in Appendix 1 of this chapter. If the instructor
chooses not to require students to calculate present value, the amounts can be provided to the students
with an explanation to complete the journal entries below.
On January 1, a corporation issued a $1 million, five-year, 10 percent bond that pays interest
semiannually. The market interest rate on January 1 was 12 percent.
Principal = $1,000,000
Interest payments = $50,000 ([$1,000,000 10%]/2)
NOTE: Stress that interest payments are based on the bond’s contract interest rate.
1. PV of principal, i = 6%, n = 10
2. PV of interest payments, i = 6%, n = 10
$50,000 7.36009 . . . . . . . . . . . . . . . . . . . . . . . $368,005
Selling price of bond $926,405
The journal entry to record issuing the bond is:
Cash…………………………….. 926,405
Discount on Bonds Payable…….. 73,595
Bonds Payable………….. 1,000,000
Chapter 12 Long-Term Liabilities: Bonds and Notes 239
Emphasize that Discount on Bonds Payable is a contra account that reduces the Bonds Payable account on
the balance sheet. The normal balance of Discount on Bonds Payable is a debit.
DEMONSTRATION PROBLEM—Issuance of a Bond (Premium)
The calculation for present value of bonds is covered in Appendix 1 of this chapter. If the instructor
chooses not to require students to calculate present value, the amounts can be provided to the students
with an explanation to complete the journal entries below.
NOTE: Stress that interest payments are based on the bond’s contract interest rate.
1. PV of principal, i = 5%, n = 10
2. PV of interest payments, i = 5%, n = 10
$55,000 7.72174 . . . . . . . . . . . . . . . . . . . . . . . 424,696
Selling price of bond $1,038,606
Always do a reasonableness check: Market interest rate is less than contract rate, so the bond should
sell at a premium. The calculation appears okay because $1,038,606 is more than the face value of $1
million.
GROUP LEARNING ACTIVITY—Issuance of a Bond
The calculation for present value of bonds is covered in Appendix 1 of this chapter. If the instructor
chooses not to require students to calculate present value, this activity can be omitted. Ask your students
to work in groups to determine the selling price (present value) of the bonds listed on TM 12-11. The
240 Chapter 12 Long-Term Liabilities: Bonds and Notes
LECTURE AID—Amortizing a Bond Discount Using the Straight-Line
Method
The calculation for amortization of bond discounts and premiums is covered in Appendix 1 of this
chapter. If the instructor chooses not to require students to calculate bond discounts and premiums, the
amounts can be provided with an explanation to complete the journal entries below. Refer to the previous
Demonstration Problem in which the $1 million, five-year, 10 percent bond that paid interest
semiannually was sold for $926,405 to yield the market interest rate of 12 percent. In the case of that
bond, the following statements are true:
1. The investor loans the company $926,405 by buying the bond.
3. Therefore, the investor gets $73,595 more at maturity than he or she paid for the bonds. The $73,595
4. Because the $73,595 discount is really just extra interest, it must be recorded as interest expense.
This interest must be spread across the five-year term of the bond. The process of recognizing a
portion of the discount as interest each time an interest payment is made to the bondholder is called
amortizing the discount.
Straight-line amortization of a bond discount is similar to straight-line depreciation. The discount is
amortized evenly over the bond’s life. The bond mentioned previously has a life of five years or a total of
The journal entry to record the interest payment and discount amortization is:
Interest Expense…………….……. 57,359.50
Discount on Bonds Payable 7,359.50
Cash ($1,000,000 5%)… 50,000.00
The process for straight-line amortizing the premium for bonds sold at a premium is to reduce the interest
expense each payment period. If we use the data from the Demonstration Problem above for bonds sold at
Chapter 12 Long-Term Liabilities: Bonds and Notes 241
DEMONSTRATION PROBLEM—Bond Redemption
Using the Demonstration Problems above, the journal entry to record the bond redemption would be:
Bonds Payable 1,000,000
Cash 1,000,000
OBJECTIVE 4
Describe and illustrate the accounting for installment notes.
SYNOPSIS
An alternative to bonds is the issuance of installment notes. These notes require equal periodic payments
for the term of the note; each payment includes interest on the outstanding balance and a portion of the
principal. These notes are similar to paying a mortgage and are often secured by specific assets. At the
Key Terms and Definitions
• Installment Note – A debt that requires the borrower to make equal periodic payments to the
lender for the term of the note.
• Mortgage Note – An installment note that may be secured by a pledge of the borrower’s assets.
Relevant Example Exercises and Exhibits
• Example Exercise 12-8 Journalizing Installment Notes
• Exhibit 4 – Amortization of Installment Notes
SUGGESTED APPROACH
242 Chapter 12 Long-Term Liabilities: Bonds and Notes
pointing out that the majority of the payments early in the process go to cover interest and a small
percentage goes to retiring the principal. Later in the loan payment cycle, more of the payment goes to
retire the principal and less to pay the interest. Exhibit 3 in the book will help demonstrate this concept.
Demonstration Problem—Installment Notes
B & H Manufacturing is considering purchasing a new piece of equipment. The cost of the equipment is
$50,000. The vendor offers financing for 5 years at an interest rate of 7%. What are the annual payments
for the equipment?
Step One: Find the present value of an ordinary annuity for $1 where n = 5 and i = 7% in the table in
Appendix A of the textbook.
Answer: 4.10020
Step Two: Divide the principal amount by this multiplier.
Answer: $50,000/4.10020 = $12,194.53 or $12,195 per year rounded up.
Step Three: Set up a payment schedule.
Year
Beginning
Principal
Payment
Interest
Expense
Decrease in
Notes Payable
Ending
Principal
1
50,000
12,195
50,000 × .07 =
3,500
8,695
41,305
2
41,305
12,195
41,305 × .07 =
2,891
9,304
32,001
3
32,001
12,195
2,240
9,955
22,046
4
22,046
12,195
22,046 × .07 =
1,543
10,652
11,395
5
11,395
12,195
11,395 × .07 =
11,395
0